I have noted in the past a large portion of my income comes from stock based incentives. Today I’d like to talk to you about Stock Incentives: Stock Options and RSUs (Restricted Stock Units). Everything to consider with respect to Golden Parachutes.
The Goal of Stock Incentive Plans: Stock Options and RSUs
So let’s start off by understanding the goals of Stock Options and RSUs (Restricted Stock Units). Companies have two goals in mind when they issue stock compensation.
- They want to keep their key performers, the people who are the stars.
- They want to align these performers goals with what would best help the company.
The idea behind both RSUs and Stock Options to fulfill these two goals. Each however does so in a different manner.
Defining Stock Options
I will to be the first to admit I have limited exposure to stock options. My company deals almost exclusively in RSUs. Still in the past my company did Stock Options and I have worked at other employers that did so. As such I do have some understand of how they work. So what are stock options?
Stock Options from an incentive perspective are very similar to stock options you would buy on the open market. They are essentially an agreement for your company to sell you their stock at a given price (called the exercise price) sometime in the future (the vesting period). When the vesting point arrives you have the option to exercise the option, thus buying the stock at the given price regardless of the current market price. That option lasts for some period of time until it expires, becoming worthless.
Taxation of a Stock Option
Once you choose to execute you technically have a choice, immediately sell the stock or hold the stock until long term capital gains take effect (1 year). In essence you get to choose when you will be taxed and at what capital gains rate. Taxation is based on the difference between the sales price and exercise price which also represents the value of options to the employee.
Stock Options are Best For High Growth Companies
Immediately selling the stock would give you a profit equal to the current market price of the stock minus your exercise price. At a point where the market price is below the exercise price you would not want to execute a stock option as buying the stock would be cheaper outright. As such stock options are only beneficial to an employee when the stock option rises. The more it rises the better it is for the individual. They can be fairly lucrative to the individual if you work for a growth company where the price is expected to go up considerably. That being said I work for an S&P 500 company, so growth is expected to be slow based on company size. A stock option would thus be less beneficial to me.
Private Smaller Companies tend to like Stock Options
Anyway, options align your rewards with actions that would lead to a higher price for the company. Or at least so the expectation goes when we ignore things like short term rises in stock price. If you are in a low growth company that impact may be significantly reduced by low expected future price increase. At a large company they also may be damaged by your ability to impact the price of the entire company. As such they tend to be utilized more in private companies in early stages. Stock options ultimately expire and if they never rise above the exercise price then they are essentially worthless. Worthless incentives are not really incentives.
RSUs (Restricted Stock Units), meanwhile, are actual grants of stock. They do not have an exercise price but instead you are given shares after a predetermined vesting period. The allotment of shares is valued at whatever the current price is when they vest. As such no matter what growth rate or increase the company has, they always hold some value.
While RSUs are actual grants of stock, until they vest you will have no voting rights or dividends. This changes at vesting when typically you are given actual stock though some companies give cash in lieu of stock. In either case the value at vesting (either cash amount or market price of the stock) is taxed as ordinary income.
Taxation of RSUs
At exercise most companies, but not all, withhold stock in a proportion equal to the tax amount on the purchase of stock. If you recall from my post on estimated taxes, my company withholds for these issuances at a 40% rate for which I have no input or choice. Unlike a stock option, where you can choose when to exercise and thus can control when taxation occurs, RSUs execute immediately at vesting. As such you do not control when the taxes will hit. Any gains beyond the purchase price are subject to capital gains rates. So holding more than 1 year would result in Long term capital gains rates instead of ordinary income rates for any gains from exercise price.
Don’t Hold for Long Term Capital Gains
Now a note, in both cases holding your company stock can result in lower term capital gains. However, it is a bad move to hold your company’s stock for long term gains. Holding these vested amounts is the functional equivalent of you choosing to purchase your company’s stock, since it is part of your compensation. As noted previously I never recommend purchasing your company’s stock. If your employer were to falter better to only have your income at risk rather than your income and assets. People that worked at Enron will tell you all about that risk if given the chance. So based on this guidance other than timing the two have the same tax impact to you. The value of the incentive, however calculated, will cost you ordinary tax rates.
Large Companies Prefer RSUs
Large companies like mine tend to favor RSUs given they have value even if the stock does not rise. These companies tend to grow at a lower rate, and as such the opportunity to make money off options is significantly reduced. Low opportunity would mean low incentive, so it makes sense. At least with RSUs employees receive some value.
The Downside of Stock Incentives: Golden Handcuffs versus Golden Parachutes.
RSUs and Stock Options have great advantages to you, but they have one major downside. I alluded to it with the goals I listed for offering these to employees. Essentially significant stock incentives become two things to an employee. First they tend to become a golden parachute. For most but not all employees if they are laid off these benefits vest immediately and pay out. As such in a way they cushion some risk if your employer decides to lay you off.
However on the flip side they also can create a barrier to you leaving your company. Most stock incentives come with clauses where if you quit you forfeit your benefits. As such they act as a sort of golden handcuff, making it costly for you to go somewhere else. I’m not currently looking for another company nor am I in fear of a layoff, but if I were both of these would apply to my situation. It’s interesting to think about how this money both makes my risk of job loss less but also creates a much bigger hurdle for changing companies.
My RSUs are Definitely Handcuffs
In fact in my case it leads to an even more unique situation. You see my base pay is largely uncompetitive with the market. But my stock incentives more then make up for that, in fact making it costly to leave. So in a way it enters me in a catch 22 where to go anywhere else now is expensive. However if I were looking to leave, waiting until the stock price declines might be too late. Job opportunities would dry up. If I were actually looking to leave it would in effect handcuff me in. Hence our article a few months back about working on base pay increases now.
Do you receive RSUs, Stock Options, or other stock incentives?