For a long time in the equity compensation world, the stock option was king. Top-level executives and key employees could look forward to being granted the opportunity to purchase company stock in hopes that the stock price would continue to rise, generating wealth for the employees as it did so. This was a great plan, until the stock price didn’t continue to rise or worse, the stock price declined. This, along with other concerns and the desire to have other compensation options, prompted the development of the restricted stock unit plan.
Many publicly traded tech companies, among others, are now offering restricted stock units to their employees to reduce the downside potential of stock prices. In fact, Bill Gates has been a big proponent of restricted stock units and preferred stock offerings, saying the variation of employee stock options is simply too great for most employees.
We know from experience that not every employer follows the Microsoft blueprint. Some may not even offer the option of restricted stock units. Other companies may offer both employee stock options and restricted stock units, asking you to decide how you receive your equity compensation. Still, others may only offer restricted stock units. Regardless of what is currently available to you, it is important to understand the differences between restricted stock units vs. options in the case you are offered either or both in the future.
Advantages and Disadvantages of Restricted Stock Units vs. Options
When it comes to executive compensation plans, it’s no surprise that stock options and restricted stock units (RSU) top the list in terms of popularity and effectiveness. To better understand the differences between stock options and RSUs, let’s take a look at the advantages and disadvantages of each.
Employee Stock Options
In general, stock options are granted to top-level executives and key employees as an opportunity to purchase a certain amount of company shares at a given price, which is identified ahead of time. This is called a strike price. Once the employee exercises their stock option by purchasing the shares at the strike price, they have the option to hold the shares, sell the shares, or even execute a stock swap of the shares down the road.
There are two types of employee stock options: incentive stock options and non-qualified stock options. However, for purposes of this article, we’ll focus on non-qualified stock options because they tend to be more prevalent in the equity compensation world.
One of the advantages of non-qualified stock options is that they can be granted to employees as well as non-employees, so if you do any consulting work with other companies, you might have the opportunity to be compensated in non-qualified stock options.
Another benefit of these options is that they can be exercised at any time, there typically is no vesting scheduled that you are required to fulfill before exercising your stock options. Although many companies will require you to have worked for them for a certain amount of time before they offer stock options.
The main benefit of utilizing a non-qualified stock option is the opportunity to purchase company stock at a low strike price and capitalize down the road by selling it for a profit as the stock price rises. A disadvantage of this type is that non-qualified stock options are taxed at your ordinary income tax rate during the year in which you exercise them.
Restricted Stock Units
As mentioned before, RSUs are another form of equity compensation similar to stock options. However, RSUs are assigned a predetermined vesting schedule. When the stock units are fully vested, you can often choose whether or not you want to receive the cash equivalent or the shares themselves.
One of the advantages of RSUs is that many times a portion of the shares can be withheld to pay the income tax owed at the time they become fully vested rather than having to write a check to the IRS. Another obvious benefit, probably the most important, is that you receive the shares or cash equivalent at the time of vesting for the current market value rather than hoping that your stock price exceeds your strike price in the case of employee stock options.
The main disadvantage of restricted stock units is that, because you receive the shares at the time of vesting, you don’t have an opportunity to gain further equity beyond the market value of the stock. This is a tradeoff—as you give up the risk related to employee stock options, you give up the potential upside as well.
Which Are Better for Your Portfolio?
The top three factors to consider when looking into the most effective investment strategies for top-level executives are asset allocation, concentrated stock management, and equity compensation planning. So when asking yourself which option is best for your portfolio, you should consider these factors.
While equity compensation is the goal of this exercise, asset allocation and concentrated stock management come into play as well. In regards to concentrated stock, RSUs give you the option to pay for the taxable amount by using a portion of your compensated shares. This is actually helpful in lowering your concentrated stock position and allowing you to keep more cash on hand or more funds invested in other asset classes.
The purpose of asset allocation is to mitigate and manage the risk in your portfolio. One way to limit your risk is by utilizing RSUs, or at least a larger portion of your equity compensation in RSUs, rather than stock options. This limits the downside potential that you could see if the strike price on your stock option is higher than the current or future market value of the stock.
So, all things equal, restricted stock units may offer less risk for your portfolio. On the flip side, stock options offer greater upside potential. One thing to always consider, however, is that with any financial decision, you need to take into account your own personal situation. Work with an experienced executive financial advisor that specializes in equity compensation planning, as well as a trusted tax advisor that can shed light on the taxable implication of these decisions.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for equity compensation strategies and financial planning for high income earners. For more information on how Wade and the Carpenter Team can advise you on restricted stock units and employee stock options, reach out today for a complimentary consultation.
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