Tuesday, February 3, 2015

Pros and cons between options and RSUs.

Living at Sillicon Valley a lot of people work for startups. From time to time, I run into people who are confused by the differences between RSUs and options and don't understand the conditions in which  one is better than the other.

For RSUs, one needs to pay income tax on it according to the share price on the date they are granted, For example if one is granted 100 shares on Jan 1, 2015 and the share price is $10, one needs to pay income tax for 100*10. The 1000 is considered as income. From now on, it just works as any individual stock. The cost basis is 1000, depending when one sells, one pays long term or short term capital gains or has losses if the price drops lower than $10 per share.

For options, one can choose to exercise it or not on the granted day. One only pays income taxes when one exercises it. Note that Incentive Stock Options (ISOs), and Non-qualified Stock Options (NSOs) have different tax treatment under the alternative minimum tax (AMT) regime. Discussion of the differing treatments under AMT are beyond the scope of this blog post.

Pros for RSU: it is guaranteed money if one sells right away when granted. In this way, it just works as a bonus.
Cons for RSU: one may lose money on it if one doesn't sell it right away and the value drops to lower than the taxes one has paid.

Pros for stock options: one never really loses money on it in most cases, but may not be worth any penny either if the stock price doesn't increase.

At the first glance one always pay the income taxes on both RSU and options, but why do people working for startups prefer to have options than RSU?

One can do earlier exercise for options and end to paying long term capital gains instead of income taxes upon selling appreciated stock. Most startups offer the earlier exercise policy for options for earlier employees. Earlier exercise means the employee can buy the options at the strike price when he starts to work. In this way, as long as one holds the stocks over a year, one ends up to pay long term capital gains instead of income taxes.

For most highly paid engineers, the income tax rate for the part over $411k is around 35%, but the long term capital gains tax rate is around 25%.  The after tax value of $4M in RSUs is  $2.4M (with a maximum tax rate of 39%), with earlier exercised options one ends up with 3M. The difference is substantial here. Note that in California state income taxes applies as well.

Acknowledged the information to An Engineer's Guide to Silicon Valley Startups. A great book for people who likes to work for Startups!

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