Choosing the Best Equity Compensation: RSU vs. Stock Options

As a founder, you are tasked with balancing limited resources while attracting and retaining talented employees who believe in your startup's vision. Traditional cash compensation often falls short of being competitive, especially in the early stages of growth. To address this issue, equity-based incentives such as Restricted Stock Units (RSUs) and stock options can be powerful tools in compensation packages, offering employees a sense of ownership in the company.

While both RSUs and stock options can help you achieve similar goals, they operate differently and provide distinct benefits depending on your startup's financial standing and long-term objectives. Choosing the wrong equity compensation tools without fully understanding their differences could lead to financial inefficiencies, unmet employee expectations, or even legal complexities down the line.

This blog explores the distinctions between RSUs and stock options, helping you make informed decisions aligning with your startup's needs. Keep reading to learn more.

What are RSUs?

Restricted Stock Units (RSUs) are a type of equity compensation used by startups and established companies to incentivize employees. Unlike stock options, RSUs don't require employees to purchase shares of stock. Instead, they represent a promise to deliver actual shares of company stock once specific conditions, such as a vesting schedule, are met.

How do RSUs work?

When you grant RSUs to an employee, you set conditions they must meet to receive a specific number of shares. These conditions often include a vesting schedule, which defines when and how the shares will become available. Vesting schedules can be based on a specific length of time (e.g., four years with a one-year cliff) or performance goals (e.g., achieving revenue targets).

Once the vesting conditions are satisfied, the RSU grants automatically convert into actual shares of your company stock. This seamless process makes RSUs straightforward and attractive for employees, especially compared to stock options, which require a purchase action.

Tax implications of RSUs

When RSUs vest, they are treated as ordinary income, with the taxable amount equaling the Fair Market Value (FMV) of the shares when delivery is made to the employee. Employees may owe additional taxes if they hold onto the shares and sell them later at a profit. However, RSUs also provide immediate value, unlike stock options, which may remain underwater if the stock price doesn't increase.

From your company's perspective, RSUs are a simpler tool to administer than stock options. However, they can be costlier because they hold intrinsic value the moment they are granted. Additionally, employees are not required to pay anything out of pocket to receive RSUs, making them feel secure about their equity compensation.

What are stock options?

Stock options are a type of equity compensation which grants employees the option to purchase company shares at a specified price, known as the exercise or strike price. However, employees can only exercise stock options after meeting specific vesting conditions, which are typically tied to time or performance milestones.

Unlike RSUs, stock options require employees to take an active step by purchasing the shares. The primary appeal lies in the potential to benefit from your company's growth. If the company's stock price increases after the option is granted, employees can exercise their options to purchase shares at the lower strike price. They can then sell them on the open market at a higher market price to book a profit.

Types of stock options

Following are the two main types of stock options:

• Incentive Stock Options (ISOs): These are typically offered to employees and come with certain tax advantages. When ISOs are exercised, employees generally do not owe taxes immediately but may face Alternative Minimum Tax (AMT). Taxes are payable when the shares are sold. If the shares are held for a specific period, the capital gains tax rate may be lower.
• Non-Qualified Stock Options (NSOs): These can be offered to employees, directors, contractors, and others. NSOs do not qualify for special tax treatments like ISOs. When employees exercise NSOs, the gap between the exercise price and the fair market value of the shares is taxable as ordinary income. The company may also need to withhold taxes at the time of exercise.

Stock options enable you to align employee interests with your company's growth. They are especially effective for early-stage startups with limited cash flow, as they allow you to offer high-value compensation without immediate cash outlays. When structured correctly, stock options provide employees with an incentive to contribute to your company's long-term success. This makes them a popular choice in equity compensation discussions around RSU vs stock options.

Key differences between RSUs and stock options

These differences between RSU and stock options can significantly impact the employees' work experience and financial planning. Here is a detailed breakdown of the key distinctions:

Taxation

RSUs are taxable as ordinary income upon vesting, regardless of whether your employees sell the shares. The taxable amount is based on the FMV of the shares on the vesting date. Stock options, however, are taxed only when exercised. ISOs may qualify for lower capital gains taxes if held for the required period, whereas NSOs are taxed as income at the time of exercise.

Upfront costs

RSUs require no upfront payment from employees, as they automatically convert into shares upon vesting. This makes RSUs a straightforward option for employees. Stock options, however, require employees to purchase shares at the exercise (strike) price. This can involve a significant upfront cost, particularly if the company's valuation is high.

Risk

RSUs carry less risk because employees will receive the shares as long as vesting conditions are met, irrespective of the company's performance. In contrast, employee stock options involve the risk that the current market price of the stock may never exceed the exercise price, rendering the options worthless.

Reward potential

Stock options typically offer greater upside potential, as employees can buy shares at a lower price and benefit from future price appreciation. RSUs offer more certainty, as employees receive actual shares, but the rewards might be lower if the company's stock does not increase significantly.

Vesting conditions

Both RSUs and stock options have vesting conditions. RSUs often vest based on performance metrics or a given period of time. Stock options might include milestone-based vesting, adding more flexibility for early-stage startups looking to align employee incentives with company growth.

Dilution of ownership

RSUs represent actual shares issued upon vesting, which means they can dilute the ownership percentage of existing shareholders once the shares are granted. Stock options only dilute ownership when they are exercised by the employee, potentially delaying the impact on ownership.

Flexibility in timing

Stock options offer flexibility in terms of when employees can exercise their options, allowing them to wait for a favorable share price. Unlike stock options, RSUs don't offer flexibility, as shares are automatically transferred upon vesting, regardless of market value.

When to choose RSUs over stock options?

As a founder, deciding between RSU vs stock options depends on your startup's stage, growth trajectory, and strategic goals. While stock options are often associated with early-stage startups, RSUs can be a better fit in specific scenarios, particularly for later-stage companies or those with a stable valuation. 

RSUs tend to dominate in industries where equity compensation is standard for attracting top talent. In addition to tech, sectors like finance, healthcare, and even mature startups nearing IPOs frequently lean toward RSUs. These companies prioritize retention and simplicity, making RSUs the logical choice for providing employees with equity that holds clear value.

Let's explore situations where RSUs might be more advantageous and how they can align with your business objectives.

For later-stage companies or stable growth trajectories

If your company is well-established with predictable revenue and a stable or growing valuation, RSUs can be a compelling choice. They are a good option for companies where equity compensation is part of a long-term strategy rather than speculative growth.

For example, large tech companies like Amazon and Microsoft often use RSUs because their stock prices already reflect substantial value, making options less appealing to employees. In such cases, RSUs provide immediate, tangible value to employees, ensuring alignment without the complexity of strike prices and exercise decisions.

Retaining key employees without upfront costs

RSUs are particularly effective for retaining key employees, as they eliminate the financial burden associated with exercising stock options. By offering RSUs, you are giving employees guaranteed ownership in the company once vesting conditions are met. This certainty is especially valuable for roles where stability and long-term engagement are critical, such as senior management or specialized positions.

For example, in industries like pharmaceuticals or financial services, where employee turnover can be costly, RSUs are commonly used to secure loyalty and incentivize performance over a long-term horizon.

When to choose stock options over RSUs?

As a founder, stock options can be a highly strategic choice for your equity compensation plan, particularly in the early stages of your startup. When cash flow is tight, but growth potential is high, stock options enable you to offer meaningful rewards without putting immediate financial strain on your business. 

In industries like SaaS or e-commerce, where rapid scaling is critical, stock options can serve as a powerful lever to encourage innovation, collaboration, and sustained effort. By making performance the key to unlocking additional equity, you foster a culture of accountability and shared success.

Let's examine scenarios in which stock options are a better fit and how they can drive success in a high-growth environment.

Attracting talent willing to take risks

Stock options are particularly attractive to employees who are eager to take risks for a chance at significant rewards. In the early stages of your startup, you are likely seeking individuals who not only believe in your vision but are willing to contribute to its growth under uncertain conditions. Stock options create a sense of ownership, offering these employees the opportunity to benefit directly from the company's success.

For example, in industries like fintech or deep tech, where innovation is risky but potentially transformative, stock options can attract ambitious, forward-thinking individuals who prioritize long-term rewards over immediate cash payouts.

Driving employee commitment in high-growth environments

Stock options create a strong connection between employee performance and company success. When employees have the potential to profit from stock price appreciation, they are more likely to contribute actively to achieving your growth objectives. This makes stock options particularly valuable in high-growth environments where every team member's efforts can directly impact the company's valuation.

For example, a software startup aiming to double its user base within a year could tie stock option vesting to performance milestones, such as hitting key revenue or market expansion targets. This helps incentivize employees and also aligns their focus with your business goals.

Conclusion

Understanding the distinctions between RSUs and stock options is crucial for structuring effective equity compensation that aligns with your startup's objectives. RSUs are ideal for later-stage companies with stable growth, offering employees a straightforward path to ownership without upfront costs. On the other hand, stock options are better suited for early-stage startups, providing employees with the potential for significant financial rewards and aligning their interests with the company's success.

At Qapita, we recognize the complexities involved in managing equity compensation. Our equity management platform, rated as #1 by G2, is designed to simplify this process, enabling you to administer both RSUs and stock options efficiently. With Qapita, you can:

• Automate vesting schedules: Seamlessly track and manage vesting timelines to ensure compliance and transparency. 
• Ensure tax compliance: Our comprehensive tools help you confidently navigate the tax implications of various equity instruments. 
• Engage employees: Provide your team with clear insights into their equity holdings, creating a sense of ownership and motivation. 

With our solutions, you can focus on scaling your business while we handle the intricacies of equity management. To learn more about how Qapita can support your startup's growth, schedule a demo with us today.

Frequently Asked Questions (FAQs)

What are RSUs and stock options in startup funding? 

RSUs and stock options are equity compensation tools used by startups to attract and retain the best talent. RSUs grant employees shares after vesting conditions are met, while stock options give employees the right to buy shares at a given price after vesting. Both methods align employee interests with company success.

How do RSUs and stock options differ in terms of vesting schedules? 

RSUs typically vest based on time or performance metrics, granting employees actual shares upon meeting these conditions. Stock options also follow vesting schedules, often time-based or tied to milestones, but require employees to purchase shares at the exercise price post-vesting, adding a layer of financial commitment. Both methods ensure commitment and performance alignment.