When you grant RSUs, you typically do not need to establish their fair market value. A financial incentive granted to employees who have met the required There is certainly something to be said for clawback provisions some firms have put in place, which surprisingly, during an interview today, Jamie Dimon said has already been executed on more than one JPMorgan employee. Problems with Stock Options Stock options have worked great for private companies for years. The recipient of an RSU will gain shareholder rights if the company gives the person stock not cash upon vesting.
If you have a job offer at a tech startup, you may have to choose between more cash or more stock options in the company. Here's how consider the tradeoffs.
How Stock Options Work
If a company's stock isn't publicly traded, employees can be restricted by contract to whom they can sell the stock until the company goes public. Some companies might set a minimum amount of time employees need to hold on to the stock before selling it, so you might not be able to cash out your stock options as soon as you exercise them. If the stock's market value falls below the strike price, there usually is no reason to use the option, since it would be cheaper to simply buy the stock on the open market than buy it with the option.
Deciding when to exercise an option before it expires partly involves determining whether you think your company's stock will continue to increase in value, giving you an incentive to hold on to the option later. For tax purposes, stock options are divided into incentive stock options and non-qualified stock options.
Incentive options allow employees to wait to pay tax on the stock options until the employees sell the underlying stock and pay capital gains, rather than ordinary income tax on the proceeds, which usually means a lower tax bill. With non-qualified stock options, employees must pay ordinary income tax on the difference between the strike price and the market price on the date the option is exercised, even if the employees intend to hold on to the actual stock.
Steven Melendez is an independent journalist with a background in technology and business.. He has written for a variety of business publications and was awarded the Knight Foundation scholarship to Northwestern University's Medill School of Journalism.
This is a great benefit of ISOs — they can help employees reduce their tax obligation. Most employees wait until the company is sold to exercise their options a same-day sale. In one day, they both exercise their options for shares and sell those shares to the purchaser of the company. This disqualifies them from receiving long-term capital gains tax treatment. They are instead taxed at the short-term capital gains rate, which is equivalent to their ordinary income tax rate.
What would happen if Mary did not exercise until the company sells? Upon sale of the stock, Mary would pay taxes at the ordinary income tax rate. These tax saving can be realized by all employees, even if their options have not vested, as long as they have the choice to early exercise their options. There are some risks though. Read our discussion of early exercise here.
In conclusion, the upside potential and tax treatment of options, especially ISOs, have made them popular with high-growth private companies. Stock options have worked great for private companies for years. But there are some drawbacks.
For one thing, their biggest strength is also their weakness. After all, the point is to incent them to help the company grow. These scenarios can lead to employees with out-of-the-money options. Most of the time, these scenarios require re-issuing options to employees to keep them motivated.
Re-issuing stock options is painful and costly. Stock options turn your employees into official shareholders once they exercise. And they have a legal right to exercise their shares as soon as their shares vest. So granting options will almost guarantee the increase of your shareholder base, and shareholders come with a bunch of baggage.
For example, in the U. Many successful companies exceed this threshold before they IPO. This is one reason why Facebook stopped issuing options. Shareholders also have voting and information rights. You may not want to have to disclose sensitive company information to a disgruntled employee who exercises options on their way out the door. For private companies, granting stock options will also require a A valuation. Restricted Stock Units seem like a natural fit because they are quite similar to options.
RSUs are often subject to vesting. Employees with vested RSUs have to wait for the vesting to get cash or stock. It is common to vest RSUs over time just like options. You can also vest RSUs using milestone triggers like achieving a certain amount of revenue or even the sale of the company. RSUs do not have a strike price. This means that they will have some value as long as common stock has value. This can be a huge benefit for employees. Because RSUs do not have a strike price, they have better downside protection relative to options.
Securities with downside protection have features that protect or enhance their value even when a company is performing more poorly than expected. When you grant RSUs, you typically do not need to establish their fair market value. This means you do not need to pay for a A valuation. Many private companies still want to know their common stock value for other reasons like ASC , but it is not a requirement for granting RSUs.
RSU recipients do not become shareholders until they receive stock. Many receive cash instead of stock, so unless they hold stock, they do not have shareholder rights. This may be less valuable to employees but is generally better for the company. We put together a comparison table to help out. We also highlighted the key differences in yellow. An RSU with equivalent vesting will be more valuable than an option.
This is because RSUs have more downside protection. This means you are giving more to your employees. Giving more may be good or bad depending on your goals. This vesting trigger is common with RSUs. Having fewer shareholders is generally good for a company. The one area where options are superior is taxation. Therefore they pay taxes at the higher ordinary income tax rate anyway. Also, though RSUs are taxed at vesting at ordinary income rates, any subsequent gains could be taxed as long-term capital gains.
So the advantages of options may not be as big as you might think. And there are certainly some real advantages to RSUs. Public companies use RSUs frequently. They often combine RSU grants with other forms of compensation including options. Vesting refers to the employee gaining ownership over the options, and vesting motivates the worker to stay with the firm until the options vest.
The firm retains an experienced manager for two additional years, and the employee profits from the stock option exercise. Since the employee owns the options for shares after two years, the manager may leave the firm and retain the stock options until the options expire.
This arrangement gives the manager the opportunity to profit from a stock price increase down the road. This eliminates that need for the worker to purchase the shares before the stock is sold, and this structure makes the options more valuable.
A financial incentive granted to employees who have met the required Vest fleece is a slang term used to describe a situation in which
RSUs vs. Stock Options
Employee stock options generally are good for a limited duration. There usually is a delay between when a stock option is issued to an employee and when it becomes eligible to be used through a process called vesting. Cash vs. Cashless Exercise – The Stock Option Conundrum May 4, By Daniel Zajac, CFP®, AIF®, CLU® 3 Comments Evaluating whether to employ a cash or cashless exercise of your stock options can be difficult. Taxes do need to be paid, however, if a stock dividend has a cash-dividend option, even if the shares are kept instead of the cash. Cash vs. Stock Dividends.