The types of equity grants being offered these days are different than what was offered in the past. Ten or 15 years ago, the vast majority of grants were in the form of stock options. Today, Restricted Stock Units (RSUs) are much more common.
Many people within the life sciences sector are offered RSUs or stocks options when they are hired, or as part of their annual performance and compensation reviews. In many cases, you will be given the choice of receiving RSU or stock options. Are you better off choosing RSUs or stock options? This is a difficult decision to make, and the answer depends on many factors.
What is an RSU?
Restricted stock units represent a transfer of company stock from the employer to an employee that is based on a vesting schedule. When RSUs vest, the value of the grants is taxed as ordinary income. Understanding your vesting schedule allows you to estimate your future income. RSUs are basically a bookkeeping entry until the grants vest.
What is a stock option?
A stock option grant gives you the right to buy company stock at a certain price (the grant price), beginning on a certain date in the future. After your stock options vest, you have the option of exercising the options at the grant price. For that to be worthwhile, the market price of the stock must be higher than the grant price at the time of exercise. When this happens, your options are “in the money.” There are two different types of stock options—non-qualified and incentive stock options (ISOs). They differ mainly based on their tax treatment.
How to Compare and Choose?
In general, the value of RSUs is much more predictable. Once the grants vest, you receive the stock. You can then simply track the stock price and plan for when you may want to sell. You don’t need an in-depth tax strategy, because once the shares vest, they are taxed as ordinary income. Your estimated taxes will be easy to predict based on your compensation and the current stock price.
As for options, they are much more unpredictable and riskier in nature but have a much larger upside potential than RSUs. An increase in the stock price could mean a much larger payout, assuming you exercise and sell at the right time.
So how do you choose between RSUs and stock options—and what percentage of each is right for you? To answer this question, you need to examine it from multiple perspectives, including:
1. Your current financial situation
Understand your current financial situation and whether you will need to access cash-flow in the near future. RSUs will be a better option if you need cash in the near term. They enable you to determine the amount of compensation you receive, when you receive it, and allow you to liquidate right away.
2. Your financial planning goals
If you are on track toward meeting a retirement goal that is 10+ years out, it makes sense to choose options over RSUs. On the other hand, if you want to earmark this equity compensation for a retirement or education goal that is in five years or less, opting for more RSUs might be a better choice. Due to stock price fluctuations, you cannot fully know the value of your future proceeds, therefore, additional planning is needed. Be sure to understand and plan for various goals and earmark cash flow as well as savings and bonuses toward those goals. Company stock will fluctuate in value; therefore, you might want to treat it as a bonus income.
3. Your tolerance for risk
RSUs are better suited for investors with a lower risk tolerance, while options are better suited for investors with a higher risk tolerance, due to their volatile nature. RSUs are more predictable, even though what you receive still depends on the stock price. On other hand, options could end up expiring out of the money and worthless due to their volatile nature. If your short and intermediate goals are well-funded and you’re on track for meeting your long-term goals, you may be able to tolerate more risk and choose more options.
4. Your level of portfolio concentration
Many workers in the life sciences sector build wealth through concentrated positions. Remember, you can’t control what happens in the stock market. However, if your entire net worth is tied to one company’s stock, you should consider diversifying. If you already have a concentrated position in your company’s stock, you may want to choose RSUs, as they are easier to sell. On other hand, stock options can be a great wealth building tool once you have a diversified portfolio, and your overall risk exposure is not too high.
Don’t assume that equity compensation grants alone will enable you to achieve all your financial goals. While they can create tremendous wealth, they can also be unpredictable. In the end, holding a mix of RSUs and stock option grants may be the most advantageous strategy. The exact allocation percentages will depend on your financial situation, tolerance for risk, and timeframe.
About the Author
Beata Dragovics is the founder of Freedom Trail Financial, an independent wealth management firm. Freedom Trail Financial works with biotech, pharma and tech professionals, families, and women.
Beata works with clients to develop comprehensive and customized financial planning, investment management, and equity compensation solutions that are tailored to help achieve professional, financial, and personal goals. The firm specializes in helping clients with equity compensation strategies to maximize their company stock and option holdings as part of their extensive and holistic plan.
As the principal and a financial advisor at Freedom Trail Financial, Beata is a continuous resource to her clients in times of change. She helps clients think differently about their future, clarify their goals, and see how financial planning can be in alignment with their personal values and lives.
Beata is a CERTIFIED FINANCIAL PLANNER™ practitioner and earned her bachelor’s degree in business management from the Budapest Business School and her master’s degree in financial planning from the College for Financial Planning. She holds the FINRA Series 7 and 66 securities registrations.