Why Restricted Stock Is Better Than Stock Options.
Many companies are concerned by the Financial Accounting Standards Board (FASB) recommendation that stock options be shown on the company's expense sheet. Especially high-tech and start-up companies are concerned because they fear losing one of their great recruiting and motivating tools. But there's no need to worry because there is already a better compensation choice, restricted stock options.
Motivation Through Restricted Stock.
Issuing restricted stock is a better motivating tool than granting stock options for two reasons.
First, many employees don't understand stock options. They don't know that they have to take action in order to realize any gain. It is far easier for them to understand a vesting period on restricted stock. The second reason is that restricted stock can't become worthless like stock options. Even if the stock price falls, the restricted stock retains some intrinsic value.
The math is fairly simple. A stock option grant with a strike price of $10 has no value when the stock trades at $8. Restricted stock awarded when trading at $10 is still worth $8. Meanwhile, the stock option has lost 100% of its value while the restricted stock has only lost 20% of its value.
Employee Ownership Through Restricted Stock.
One of the advantages restricted stock has from a management perspective is that as a motivating tool it allows employees to think, and act, like owners. When a restricted stock award vests, the employee who received the restricted stock automatically becomes an owner of the company.
The employee doesn't have to take any action to achieve ownership and is now entitled to vote at the annual meeting. Becoming a stakeholder also encourages employees to focus more on meeting corporate goals.
Stock options, on the other hand, do little to instill a sense of ownership and are usually viewed as a high-risk gamble that has a potentially great reward.
An employee may invest a couple of years helping a company grow and prosper and be compensated with stock options but their loyalty is to raise the stock price so they can cash out and make a bundle. These employees often choose actions that will raise stock price in the short term (to increase their potential gain) rather than taking the long view that ultimately helps the company grow and prosper over time.
Restricted Stock Supporters.
The world's biggest online merchant, Amazon, knows how to sell to its employees, as well as to the general public. Amazon. co. uk notes that all their employees are allocated a number of Amazon restricted stock units when they join. The Altria Group, Inc. also went that route when they announced they made equity awards in shares of restricted stock rather than fixed-price stock options. Dell Computer Corp., Cendant Corp., and DaimlerChrysler AG have also moved toward restricted stock in lieu of stock options.
Restricted Stock FAQ.
If you have questions about restricted stock awards as a motivating form of compensation, see the Restricted Stock FAQ. There is a comparable FAQ about stock options here.
How Do Stock Options and RSUs Differ?
One of the biggest changes in the structure of Silicon Valley private company compensation over the past five years has been the increasing use of Restricted Stock Units (RSUs). I’ve been in the technology business more than 30 years and throughout that time stock options have almost exclusively been the means by which startup employees shared in their employers’ success. That all changed in 2007 when Microsoft invested in Facebook. To understand why RSUs emerged as a popular form of compensation, we need to look at how RSUs and stock options differ.
History of the Stock Option in Silicon Valley.
More than 40 years ago a very intelligent attorney in Silicon Valley designed a capital structure for startups that helped facilitate the high-tech boom. His intention was to build a system that was attractive for Venture Capitalists and provided employees a significant incentive to grow the value of their companies.
To accomplish his goal he created a capital structure that issued Convertible Preferred Stock to the Venture Capitalists and Common Stock (in the form of stock options) to employees. The Preferred Stock would ultimately convert into Common Stock if the company were to go public or get acquired, but would have unique rights that would make a Preferred share appear more valuable than a Common share. I say appear because it was highly unlikely that the Preferred Stock’s unique rights, like the possibility of dividends and preferential access to the proceeds of a liquidation, would ever come into play. However, the appearance of greater value for the Preferred Stock allowed companies to justify to the IRS the issuing of options to buy Common Stock at an exercise price equal to 1/10 th the price per share paid by the investors. Investors were happy to have a much lower exercise price than the price they paid for their Preferred Stock because it didn’t create increased dilution and it provided a tremendous incentive to attract outstanding individuals to work for their portfolio companies.
This system didn’t change much until around 10 years ago when the IRS decided that pricing options at only 1/10 th the price of the most recent price paid by outside investors represented too large an untaxed benefit at the time of option grant. A new requirement was placed on companies’ boards of directors (the official issuers of stock options) to set option strike prices (the price at which you could buy your Common Stock) at the fair market value of the Common Stock at the time the option was issued. This required boards to seek appraisals (also known as 409A appraisals in reference to the section of the IRS code that provides guidance on the tax treatment of equity-based instruments granted as compensation) of their Common Stock from third-party valuation experts.
Issuing stock options with exercise prices below the fair market value of the Common Stock would result in the recipient having to pay a tax on the amount by which the market value exceeds the cost to exercise. Appraisals are pursued approximately every six months to avoid employers running the risk of incurring this tax. The appraised value of the Common Stock (and thus the option exercise price) often comes in at approximately 1/3 rd the value of the latest price paid by outside investors, although the method of calculating the fair market value is far more complex.
This system continues to provide an attractive incentive to employees in all but one case – when a company raises money at a valuation well in excess of what most people would consider fair. Microsoft’s investment in Facebook in 2007 is a perfect example. Let me explain why.
Facebook changed everything.
In 2007 Facebook decided to engage a corporate partner to accelerate its advertising sales while it built its own sales team. Google and Microsoft competed for the honor of reselling Facebook’s ads. At the time Microsoft was falling desperately behind Google in the race for search engine advertising. It wanted the ability to bundle its search ads with Facebook ads to give it a competitive advantage vs. Google. Microsoft then did a very savvy thing to win the Facebook deal. It understood from years of investing in small companies that public investors do not value appreciation earned from investments . They only care about earnings from recurring operations . Therefore the price Microsoft was willing to pay to invest in Facebook didn’t matter, so they offered to invest $200 million at a $4 billion valuation as part of the reseller agreement. This was considered absurd by almost everyone in the investment world, especially given that Facebook generated annual revenue of only $153 million in 2007. Microsoft could easily afford to lose $200 million given its greater than $15 billion cash stockpile, but even that was unlikely because Microsoft had the right to be paid back first in the event Facebook was acquired by someone else.
The extremely high valuation created a recruiting nightmare for Facebook. How were they going to attract new employees if their stock options weren’t worth anything until the company generated value in excess of $1.3 billion (the likely new appraised value of the Common Stock —1/3 rd of $4 billion)? Enter the RSU.
What are RSUs?
RSUs (or Restricted Stock Units) are shares of Common Stock subject to vesting and, often, other restrictions. In the case of Facebook RSUs, they were not actual Common shares, but a “phantom stock” that could be traded in for Common shares after the company went public or was acquired. Prior to Facebook, RSUs were almost exclusively used for public company employees. Private companies tended not to issue RSUs because the recipient receives value (the number of RSUs times the ultimate liquidation price/share) whether or not the value of the company appreciates. For this reason, many people, including myself, don’t think they are an appropriate incentive for a private company employee who should be focused on growing the value of her equity. That being said RSUs are an ideal solution for a company that needs to provide an equity incentive in an environment where the current company valuation is not likely to be achieved/justified for a few years. As a result they are very common among companies that have closed financings at valuations in excess of $1 billion (Examples include AirBnB, Dropbox, Square and Twitter), but are not often found at early stage companies.
Your mileage will vary.
Employees should expect to receive fewer RSUs than stock options for the same job/company maturity because RSUs have value independent of how well the issuing company performs post grant. You should expect to receive approximately 10% fewer RSUs than Stock Options for each private company job and about 2/3 fewer RSUs than you would receive in options at a public company.
Let me provide a private company example to illustrate. Imagine a company with 10 million shares outstanding that just completed a financing at $100 per share, which translates to a $1 billion valuation. If we knew with certainty that the company would ultimately be worth $300 per share then we would need to issue 11% fewer RSUs than stock options to deliver the same net value to the employee.
Here’s a simple chart to help you visualize the example.
We never know what the ultimate value of the company will be, but you should always expect to receive fewer RSUs for the same job to get the same expected value because RSUs don’t have an exercise price.
RSUs and stock options have very different tax treatment.
The final major difference between RSUs and stock options is the way they are taxed. We covered this subject in great detail in Manage Vested RSUs Like A Cash Bonus & Consider Selling. The bottom line is RSUs are taxed as soon as they become vested and liquid. In most cases your employer will withhold some of your RSUs as payment for taxes owed at the time of vesting. In some cases you may be given the option to pay the taxes due with cash on hand so you retain all vested RSUs. In either case your RSUs are taxed at ordinary income rates, which can be as high as 48% (Federal + State) depending on the value of your RSUs and the state in which you live. As we explained in the aforementioned blog post, holding on to your RSUs is equivalent to making the decision to buy more of your company stock at the current price.
In contrast, options are not taxed until they are exercised . If you exercise your options before the value of the options has increased and file an 83(b) election (see Always File Your 83(b)) then you will not owe any taxes until they are sold. If you hold on to them, in this case for at least a year post exercise, then you will be taxed at capital gains rates, which are much lower than ordinary income rates (maximum of approximately 36% vs. 48%). If you exercise your options after they increase in value, but before you are liquid, then you are likely to owe an Alternative Minimum Tax. We highly recommend you consult with a tax advisor before making this decision. Please see 11 Questions to Ask When You Choose a Tax Accountant to learn how to select a Tax Advisor.
Most people do not exercise their options until their employer has gone public. At that point it is possible to exercise and sell at least enough shares to cover the ordinary income tax owed on the appreciation of the options. The good news is, unlike RSUs, you can defer the exercise of your options to a point in time when your tax rate is relatively low. For example you might wait until you buy a house and are able to deduct most of your mortgage payment and real estate taxes. Or you might wait until you benefit from tax losses harvested by an investment management service like Wealthfront.
We are here to help.
RSUs and stock options were designed for very different purposes. That’s why the tax treatment and amount you should expect to receive differ so much. We strongly believe that with a better understanding of how their use has evolved you will be able to make better decisions on what constitutes a fair offer and when to sell. We are also very aware of how complex and specific your own decision-making can be so please feel free to follow up with questions in our comment section — they are likely to prove helpful to others as well.
Nothing in this blog should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. This blog is not intended as investment advice, and Wealthfront does not represent in any manner that the circumstances described herein will result in any particular outcome. Graphs and other images are provided for illustrative purposes only. Our financial planning services were designed to aid our clients in preparing for their financial futures and allows them to personalize their assumptions for their portfolios. We do not intend to represent that our financial planning guidance is based on or meant to replace a comprehensive evaluation of a client’s entire personal portfolio. While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront cannot ensure the accuracy or completeness of data provided by clients or third parties. Investment advisory services are only provided to investors who become Wealthfront clients. For more information please visit wealthfront or see our Full Disclosure.
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Stock Options, Restricted Stock, Phantom Stock, Stock Appreciation Rights (SARs), and Employee Stock Purchase Plans (ESPPs)
Stock Options.
A company grants an employee options to buy a stated number of shares at a defined grant price. The options vest over a period of time or once certain individual, group, or corporate goals are met. Some companies set time-based vesting schedules, but allow options to vest sooner if performance goals are met. Once vested, the employee can exercise the option at the grant price at any time over the option term up to the expiration date. For instance, an employee might be granted the right to buy 1,000 shares at $10 per share. The options vest 25% per year over four years and have a term of 10 years. If the stock goes up, the employee will pay $10 per share to buy the stock. The difference between the $10 grant price and the exercise price is the spread. If the stock goes to $25 after seven years, and the employee exercises all options, the spread will be $15 per share.
Kinds of Options.
If all the rules for ISOs are met, then the eventual sale of the shares is called a "qualifying disposition," and the employee pays long-term capital gains tax on the total increase in value between the grant price and the sale price. The company does not take a tax deduction when there is a qualifying disposition.
Exercising an Option.
Accounting.
Restricted Stock.
Phantom Stock and Stock Appreciation Rights.
Employee Stock Purchase Plans (ESPPs)
Plans not meeting these requirements are nonqualified and do not carry any special tax advantages.
Stay Informed.
Our twice-monthly Employee Ownership Update keeps you on top of the news in this field, from legal developments to breaking research.
Related Publications.
You might be interested in our publications on this topic area; see, for example:
GPS: Restricted Stock and Restricted Stock Units.
Discusses regulatory and administrative issues for public companies that grant restricted stock and restricted stock units.
The Stock Options Book.
A comprehensive guide to employee stock options, with extensive technical details.
GPS: Stock Options.
A guide to administrative and compliance issues for stock option plans in US public companies.
GPS: ESPP (Employee Stock Purchase Plans)
Discusses regulatory and administrative issues for ESPPs, including practical examples and the financial cost of design features.
If I'd Only Known That.
True stories illustrating common mistakes in implementing and operating equity compensation plans and what to do about them.
Accounting for Equity Compensation.
A guide to accounting for stock options, ESPPs, SARs, restricted stock, and other such plans.
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Link to Us.
NCEO Membership Brochure.
Read our membership brochure (PDF) and pass it on to anyone interested in employee ownership.
Stock Options Vs. RSUs.
Companies often offer their executive team stock options and RSUs as part of the compensation package.
Executive man and woman on a downtown roof image by Scott Griessel from Fotolia.
More Articles.
How to motivate employees is a key concern for businesses. There is, of course, the time-honored enticement of higher salaries for performance superior to those of other employees. The drawback is that offering higher salaries increases the direct cost of doing business because it increases payroll costs. Another way companies motivate employees is to offer stock options and restricted stock units (or RSUs), thereby giving employees a direct stake in the company’s fortunes.
Payment in Stocks.
As an alternative form of payment, some companies offer employees the option of owning stock in the company. The better the company performs, the higher the price of its stock and the better off financially are its employees. Offering stock to employees can motivate them to perform better, benefiting the company and its employees. On the other hand, there is a downside for employees in that there is no guarantee that the company will show positive performance. If a company underperforms, the share price may well go down and employees who opted to receive stock as a form of payment may do worse than those who opted for higher pay.
Stock Options.
With stock options, you can buy company stock in the future at the price that was current when you received the stock option. For example, if your company gave you a stock option last year when the price was $100 per share and the price is currently $300 per share, you would pay only $100 per share to purchase the stock. Employers typically require that you continue to work for the company for a significant period before you are eligible to exercise your options. The expectation is that the stock price will increase so that you can earn the difference between the prices. Alternatively, you can hold on to the shares if you believe the stock price will continue to increase. But if you don’t exercise your option before a predetermined future date, your stock options may expire. Similarly, if you leave the company before exercising your stock options, you will likely lose your rights to them.
Restricted Stock Units.
Restricted stock units are another form of compensation that may involve the transfer of stocks. Companies, particularly start-ups, often offer executives a percentage of their salaries in RSUs, often as an incentive for increasing the company's stock value. The employer grants the stock to you at no cost or very little cost, sometimes as low as a penny per share. With an RSU, your employer promises to pay you with shares or the cash value of the shares if you meet certain conditions, often including a vesting period with the company. RSUs are valued through the number of shares within the unit and the stock price at the time of the grant. They also come with a required holding time, and often you must meet certain performance goals. As with stock options, you may forfeit your right to exercise an RSU if you leave the company.
Comparison.
The main difference between an RSU and a stock option is that the former may result in a direct cash outlay, whereas, in the latter case, you get shares. Of course, if you have a stock option you can choose to turn the stock into cash when you receive the option. If you have an RSU, depending on the agreement, you may not be able to receive stock, as the company may restrict you to receiving cash. The choice between receiving money or stocks may belong only to your company. While you may not have to pay out any money for an RSU grant, you'll need to pay income tax on its fair market value. Since you are restricted from selling the RSU stock for a certain period, you may wish for the stock option, which requires no income tax until you sell.
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Photo Credits.
Executive man and woman on a downtown roof image by Scott Griessel from Fotolia.
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