Not all salaries are made equal- learn about different equity types.
Equity is increasingly making its way into employee compensation packages, especially in the tech industry. However, not all equity awards are created equally.
Understanding how your benefits work is key to making the most of them and getting cashed out at the end of the day.
Let’s cover what you need to know about RSUs, NSOs and ISOs.
Companies offer equity compensation for a variety of reasons. For one, it allows them to supplement employee salaries without incurring higher up-front costs. Many also believe that giving employees a sense of ownership incentivizes them to stay longer and help grow the company.
When your employer grants RSUs, NSOs or ISOs, you won’t receive equity right away. Rather, you’ll typically receive your award in installments as the specified terms are fulfilled in a process called "vesting". These requirements may be time-based, or they may rely on the occurrence of a liquidity event, such as an IPO or acquisition.
Common types of vesting schedules include:
Restricted stock units (RSUs) are a promise from your employer that you’ll receive a specified number of shares upon vesting. RSUs are the most common type of equity award, predominantly granted at big public companies or late-stage startups.
At a public company- RSUs are as good as cash since they can be traded as soon as they're vested. At a private company, RSUs have little to no liquidity - some bigger companies have secondary markets on platforms like Forge ut by and large you'll have few options to sell until you've IPOd.
Typically, your RSU award will be based on the company valuation when you first join.
For example: If you receive $100,000 in RSUs when your company stocks are worth $50 per share, you’ll get a total of 2,000 shares.
When your RSUs vest, you’ll have to pay ordinary income tax on the total value of your shares. This includes federal income taxes, state and local tax, social security and Medicare. Then, if you hold onto your shares after they vest, you’ll have to pay capital gains taxes on your earnings once you sell.
Some employees try to hold onto their stocks for at least a year after receiving them in order to take advantage of the long-term capital gains rate. However, financial experts advise that you should think about your equity like a cash bonus. If you would spend your bonus on company stock, you should continue holding the shares. Otherwise, you should sell them.
👉 Read next: Should You Sell RSUs as They Vest?
No upfront costs
Unlike other forms of equity compensation, once your RSUs vest, you’ll receive them at no cost. Therefore, there’s no way you can lose money, making them low-risk for employees.
Stock options are known as “underwater” when the exercise price is higher than the current market value. This means that they’re worthless, since exercising would result in losing money. However, RSUs are always worth the value of the underlying share. Therefore, unless the company goes bankrupt, they always have some worth.
Fewer decisions required
When RSUs vest, they’re automatically converted into company stock. Then, you’ll be taxed as soon as they vest. Unlike other equity compensation, this doesn’t allow much room for flexibility. However, the lack of choices can also save time and mental energy.
Compared to other forms of equity compensation, RSUs are subject to relatively high taxes. Depending on your state laws and income bracket, your RSUs may be taxed at 50% or higher. Since these taxes are due upon vesting, many employees may feel pressured to sell stock to cover them.
Lower upside potential
RSUs are typically granted at successful, well-established companies. Because these firms have already reached a major milestone, they’re unlikely to see the same exponential growth as some early-stage startups.
Employee stock options (ESOs) are contracts that allow employees to purchase a certain number of company shares at a specified price. Unlike RSUs, they’re much more common at smaller private companies.
In order to understand how ESOs work, you’ll need to be familiar with the terminology surrounding stock options:
When you first receive ESOs, the exercise price will be set at the current company share price. Therefore, in order to make a profit when you exercise the option, the stock price will need to be higher than it was when you joined the firm.
For example, let’s say you receive employee stock options to buy 1,000 shares of your company at an exercise price of $10. Once your options vest, the market price has risen to $20. You have three options:
On the other hand, at the end of the vesting period, the market price may have declined to $5. In this case, your options will be “underwater,” or worthless. Therefore, you’ll have to wait until the market price rises above the strike price before exercising your options.
ESOs can be divided into two categories: non-qualified stock options (NSOs) and incentive stock options (ISOs).
Exercising your NSOs will trigger ordinary income taxes, regardless of whether or not you sell the underlying stock. In other words, you’ll pay federal, state and local income taxes, as well as social security and Medicare on the difference between the exercise price and the current market value. Then, when you sell, you’ll pay capital gains tax on the difference between the sale price of the stock and the market value when you exercised the option.
For example: Let’s say that you exercise your NSOs to buy 1,000 shares at a strike price of $10 when the market price is $20. You’ll pay ordinary tax on the $10,000 of profit. Then, you hold onto the shares for one year until the market price reaches $30, at which point you sell them all. Once you sell, you’ll pay long-term capital gains tax on the most recent profit of $10,000.
Because NSOs are typically distributed at early-stage companies, employees have the opportunity to cash in on significant gains. In some cases, successful startups may end up earning life-changing profits for fortunate employees.
Because NSOs come with few tax privileges, they’re also subject to fewer limitations. Therefore, employees can make the right decision based on circumstances without worrying about complying with guidelines.
Similar to RSUs, gains from NSOs are subject to ordinary income tax. Therefore, taxes can eat up over half of some employees’ profits. Additionally, many option holders may need to exercise their options and sell the underlying stock in order to pay taxes.
Although NSOs allow employees to buy company stock at an advantageous price, they still require a significant investment. Some employees even seek out loans or pull out savings in order to cover the initial cost.
Compared to NSOs, ISOs allow employees significant tax benefits when exercising their options. Unlike NSOs, ISO holders don’t need to pay taxes upon exercising their options. Instead, they’ll be able to wait until they sell the underlying stock, at which point they’ll be taxed on the difference between the exercise and sale prices at the capital gains rate.
These tax advantages come with a few key limitations:
Just like NSOs, ISOs usually make their way into up-and-coming firms with high growth potential. Therefore, some can prove to be a lucrative investment for employees.
ISOs offer a much more favorable tax structure than other forms of equity compensation, including deferred taxes and lower rates. These advantages can help employees retain a much larger portion of their earnings.
Although exercising ISOs doesn’t trigger taxes, it does require an investment to purchase the stocks in the first place. Depending on the exercise price and the number of shares, this can be a significant cost for some employees.
In order to take advantage of the tax benefits of ISOs, employees must follow certain rules such as minimum holding time. While this can save them a lot on taxes, it may also incentivize them to hold onto shares on the decline, leaving them worse off in the end.
While RSUs, NSOs and ISOs are all forms of equity compensation, they have their fair share of differences. RSUs tend to be a lower-risk asset, offering great certainty but lower upside potential. On the other hand, ESOs may yield high gains if the company succeeds or end up worthless if it fails.
When it comes to NSOs vs. ISOs, incentive stock options tend to be more favorable overall due to their tax benefits. However, it’s important to be mindful of the limitations, as well as the potential of triggering the alternative minimum tax.
Most companies will offer a single type of equity compensation to their employees, so it’s unlikely that you’ll have to make a choice. However, knowing the pros and cons of each can help you compare job offers and make the most of your assets.
The information provided herein is for general informational purposes only and is not intended to provide tax, legal, or investment advice and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation of any security by Candor, its employees and affiliates, or any third-party. Any expressions of opinion or assumptions are for illustrative purposes only and are subject to change without notice. Past performance is not a guarantee of future results and the opinions presented herein should not be viewed as an indicator of future performance. Investing in securities involves risk. Loss of principal is possible.
Third-party data has been obtained from sources we believe to be reliable; however, its accuracy, completeness, or reliability cannot be guaranteed. Candor does not receive compensation to promote or discuss any particular Company; however, Candor, its employees and affiliates, and/or its clients may hold positions in securities of the Companies discussed.