If you’ve worked in the tech world, chances are you’ve encountered stock incentive pay, but have you received multiple offers with different types?
About a year and a half ago, I worked with an individual (let’s call him Bob) who was trying to compare two different offers from tech companies in the area. It was not only a decision about choosing a large or small company, higher incentives or higher salary, but also a decision about the risks he was comfortable taking.
In considering an offer from a small- to mid-size technology industry player, potential employees consider the opportunities available: the technologies they will work with, the office environment, and the personal risk in salary, stock incentives, and potential financial and family impact. Small- to mid-size companies are known for focusing on:
- Salary that covers your current living expenses and needs.
- Incentives to entice you to take the risk of joining a high-potential, quickly growing company.
Below is a comparison of the two main types of incentives seen in this industry.
| Nonqualified Stock Options* | Restricted Stock Units (RSUs) |
| Value: stock price less exercise price. | Value: stock price upon vesting. |
| Vesting: generally over a few years and subject to vesting requirements/rules. | Vesting: generally over a few years and subject to vesting requirements/rules. |
| Option to buy expires in a stated time period following grant date. | Become actual shares at vesting and thus do not expire |
| Stock options that give the holder the option, but not obligation, to buy a particular security at a set price during a stated time period. | A grant of stock units, set to vest into shares of stock over time, and tied to the price of the actual traded stock. |
| Taxation: value is taxable as ordinary income at time of exercise. | Taxation: restricted stock is generally taxable as ordinary income when vested. |
| More common with early stage companies. | More common with companies with large valuations or for startup founders. |
*Nonqualified stock options are the most common form of stock options. Incentive stock options (ISOs) are limited to the extent the fair market value of the stock exceeds $100,000 during a calendar year (based on the time the options are granted).
What are the main issues surrounding each type of incentive?
Keep these things in mind when weighing your offers.
| Nonqualified Stock Options | Restricted Stock Units (RSUs) |
| Option to buy: may be worth nothing if the stock price is less than the exercise price. | Cash flow impact: tax usually paid through a portion of RSUs sold upon vesting with public companies. |
| Cash flow impact: tax usually paid through a portion of RSUs sold upon vesting with public companies. | Cash flow impact: tax usually paid through a portion of RSUs sold upon vesting with public companies. |
| Tax impact: allows for more effective tax bracket management, but may cause potential AMT issues and require estimated tax payments. | Tax impact: taxed upon vesting. |
| Investment strategy: risk of worthlessness, discount creates larger upside potential, and net worth concentration. | Investment strategy: greater downside risk protection, but less upside potential as well; net worth concentration. |
In addition, evaluating RSUs and stock options 1 to 1 is generally not appropriate. Employees will generally receive fewer RSUs than stock options for the same maturity because RSUs have value independent of how well the issuing company performs post grant. Since RSUs are not limited by an exercise price, fewer RSUs are expected to result in the same profit as a larger grant of stock options for the same company.
How do you compare competing offers with different incentive structures?
To really consider what type of structure is best for you, begin by determining your own values and risk profile.
- Do you have a high risk tolerance?
- What tax bracket are you in? If you believe your tax bracket will change over the coming years, stock options allow for planning around tax impact before expiration.
- If you received the same value in cash, would you buy your company’s stock with the entire amount? If not, then you should consider selling the position over time and develop a mechanical strategy to minimize emotional investing decisions.
This third question really looks at emotional bias and regret aversion. This is a much larger issue than many may think. Emotionally, we would like to believe that we understand the company we work for better than other investors, and we have faith in our efforts (and fellow employees’ efforts) to continue increasing the company’s value. In reality, this can lead to concentration risk with employees delaying sales of stock or exercising options since they believe the price will fluctuate in a particular manner (market timing).
The best way to address these obstacles is to identify a strategy you can consistently stick with in a systematic way to prevent emotional investment decisions. This can help prevent net worth concentration in the stock, increase diversification of your portfolio to protect your current wealth, and further your long-term goals. Each individual holds different preferences and risk tolerances that lead to differing strategies and opportunities in selling the position or maintaining a particular portion of the position.
Stock options or RSU grants are rarely the deciding factor of an offer, but a better understanding of what these incentives represent may help you in negotiating your offer and understanding the impact of holding these.
Bob ultimately decided to push for restricted stock units from the company to ensure his ownership level and take advantage of the greater downside risk protection, but each situation and individual is different. Consider discussing potential agreements with your financial advisor for an unbiased perspective. If your advisor cannot answer your questions around this, please feel free to reach out to me for a lively discussion of your situation.
