The types of equity grants being offered these days are different than what was offered in the past. Ten or 15 years ago, the vast majority of grants were in the form of stock options. Today, Restricted Stock Units (RSUs) are much more common.
Many people within the life sciences sector are offered RSUs or stocks options when they are hired, or as part of their annual performance and compensation reviews. In many cases, you will be given the choice of receiving RSU or stock options. Are you better off choosing RSUs or stock options? This is a difficult decision to make, and the answer depends on many factors.
It is important to understand the differences between RSUs and stock options and what you need to know to make the choice that’s right for your personal situation. To start, lets briefly define these two types of equity grants:
What is an RSU?
Restricted stock units represent a transfer of company stock from the employer to an employee that is based on a vesting schedule. When RSUs vest, the value of the grants is taxed as ordinary income. Understanding your vesting schedule allows you to estimate your future income. RSUs are basically a bookkeeping entry until the grants vest.
What is a stock option?
A stock option grant gives you the right to buy company stock at a certain price (the grant price), beginning on a certain date in the future. After your stock options vest, you have the option of exercising the options at the grant price. For that to be worthwhile, the market price of the stock must be higher than the grant price at the time of exercise. When this happens, your options are “in the money.”
To exercise your options, you buy the stock at the grant price. However, you will have to pay taxes on the spread—the difference between the current stock price and the grant price.
There are two different types of stock options—non-qualified and incentive stock options (ISOs). They differ mainly based on their tax treatment.
With non-qualified options, no holding period is required. If your options are in the money, they can be exercised as soon as they vest. The spread (as described above) will be taxed as ordinary income. If you decide to exercise and sell, there are no further tax implications. However, if you decide to exercise and hold the stock, long-term capital gains taxes will apply if you sell after a one-year holding period.
Incentive stock options offer preferential tax treatment. No ordinary income tax is due when you exercise. To qualify for this preferential tax treatment, however, you must hold the stock for two years from the grant date and one year from the exercise date. If you sell your shares early, the sale with be treated as a disqualifying disposition, the options become non-qualified, and taxes will be due.
If you hold the stock for one year or more from exercise and two years from the grant date, any capital gains above the grant price are also subject to long-term capital gains taxes. Note that the Tax Cuts and Jobs Act of 2017 increased both the income exemption amount as well as the income phase-out at which incentive stock options do not trigger the Alternative Minimum Tax (AMT).
How to Compare and Choose?
In general, the value of RSUs is much more predictable. Once the grants vest, you receive the stock. You can then simply track the stock price and plan for when you may want to sell. You don’t need an in-depth tax strategy, because once the shares vest, they are taxed as ordinary income. Your estimated taxes will be easy to predict based on your compensation and the current stock price.
As for options, they are much more unpredictable and riskier in nature but have a much larger upside potential than RSUs. An increase in the stock price could mean a much larger payout, assuming you exercise and sell at the right time.
So how do you choose between RSUs and stock options—and what percentage of each is right for you? To answer this question, you need to examine it from multiple perspectives, including:
- Your current financial situation
Understand your current financial situation and whether you will need to access cash-flow in the near future. RSUs will be a better option if you need cash in the near term. They enable you to determine the amount of compensation you receive, when you receive it, and allow you to liquidate right away.
- Your financial planning goals
If you are on track toward meeting a retirement goal that is 10+ years out, it makes sense to choose options over RSUs. On the other hand, if you want to earmark this equity compensation for a retirement or education goal that is in five years or less, opting for more RSUs might be a better choice. Due to stock price fluctuations, you cannot fully know the value of your future proceeds, therefore, additional planning is needed. Be sure to understand and plan for various goals and earmark cash flow as well as savings and bonuses toward those goals. Company stock will fluctuate in value; therefore, you might want to treat it as a bonus income.
- Your tolerance for risk
RSUs are better suited for investors with a lower risk tolerance, while options are better suited for investors with a higher risk tolerance, due to their volatile nature. RSUs are more predictable, even though what you receive still depends on the stock price. On other hand, options could end up expiring out of the money and worthless due to their volatile nature. If your short and intermediate goals are well-funded and you’re on track for meeting your long-term goals, you may be able to tolerate more risk and choose more options.
- Your level of portfolio concentration
Many workers in the life sciences sector build wealth through concentrated positions. Remember, you can’t control what happens in the stock market. That said, if you are working for a large company with a relatively stable stock price, RSUs are a great option. If you work for a small biotech company and you are bullish on the stock, leveraging the upside potential of stock options grants may be the better choice.
However, if your entire net worth is tied to one company’s stock, you should consider diversifying. If you already have a concentrated position in your company’s stock, you may want to choose RSUs, as they are easier to sell. On other hand, stock options can be a great wealth building tool once you have a diversified portfolio, and your overall risk exposure is not too high.
Don’t assume that equity compensation grants alone will enable you to achieve all your financial goals. While they can create tremendous wealth, they can also be unpredictable. In the end, holding a mix of RSUs and stock option grants may be the most advantageous strategy. The exact allocation percentages will depend on your financial situation, tolerance for risk, and timeframe.
If you would like to review your current portfolio or talk through your options, schedule a call today.