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The job market is gigantic today. Despite job insecurities and uncertainties, employees have multiple opportunities to prove their skills and earn attractive income. Like employees competing with each other to get their dream jobs, employers, too, compete with one another to hire the best talents for their firms.
Of the many ways to entice the right talents, providing attractive monetary compensation to employees is one of them. Offering lucrative monetary benefits helps pull new talent and also retain existing ones. One such way to do so is by providing equity to employees. In today’s article, we will study the two popular ways of equity compensation and the differences between them.
The power of equity compensation
Employees are paid a salary in cash for their work, so why pay them in equity? Well, equity compensation is one of the strategies for companies to reward employees and retain them, besides paying the regular salary.
Compensating employees with equity stocks allows them to be part owners of the firm, hence increasing their interest towards the company’s performance. Employees also get a share in the firm’s profits, which motivates them to work harder for better results.
What are stock options?
Stock option, also called Employee Stock Option Plan (ESOP), is a widespread way among corporations to provide equity compensation to employees.
It is a benefit where the company gives employees the option to purchase its stocks at a discounted price at a later date. But why would employees be interested in those stocks while they are available in the market? It is because the stocks are issued to employees at a discount, where the ESOP’s price is lower than the market price.
Stock options involve a vesting period. A vesting period here suggests the time that employees must wait to unlock the benefit. It is the period between the date on which the compensation is granted and the date when the employee receives it.
Let’s consider an example to understand better. Your company gives you a stock option on 28 March 2023 to buy 1,000 shares after one year at ₹150 per share. If you decide to buy 1,000 shares on 28 March 2024, it means the stock option is vested, i.e., the benefit is active for you to exercise.
Employees may choose to deny the stock option if it is unfavourable. If the ESOP’s price is lower than the market price, they may buy the stocks and then sell them in the market to earn profits.
What are restricted stock units?
Restricted stock unit is another way of compensating employees through equity stocks. It is where employees are granted stocks subject to certain restrictions.
Unlike stock options, employees are not given the right to buy stocks at a lower price but are directly rewarded stocks at no additional cost. However, employees receive these shares only upon fulfilling the required conditions. The condition may relate to working in the company for a specific period, achieving certain milestones, etc.
Restricted stock units often have a vesting schedule that grants the total number of stocks in parts. For example, your employer grants 1,000 units of stocks, which will be vested equally in five years, making it 200 units per year. So, you own only 200 units in the first year despite being granted 1,000 units.
Once vested, employees have the right to sell them in the stock market to benefit from changing prices.
Differences between stock options and restricted stock units
- The method of granting the benefit to employees is a major distinguisher here. While ESOP gives the benefit of buying stocks at a discount, RSUs act as a bonus compensation and provide shares free of cost.
- Employees earning ESOPs become regular shareholders of the firm with regular voting and dividend rights. RSU shareholders may not be entitled to all the rights like regular shareholders.
- Stock options can either be qualified or non-qualified. Qualified stock options have tax incentives, while non-qualified stock options are taxed similarly to the employee’s income tax slab rate. RSUs, on the other hand, are liable for capital gain tax when the units are sold.
- All units of ESOP are eligible for dividends, while only the vested units of RSUs are eligible for dividends each year.
Bottomline
Employee stock options and restricted stock units are two well-known ways of rewarding employees in equities. Some companies offer both facilities and allow employees to choose one among them, while other companies may have only one of these facilities.
If your company allows you to choose between the two, understanding the differences between restricted stock units vs options is essential to analyse what benefits you better.
FAQs
The blackout period is the time when companies restrict shareholding employees from selling their shares in the market. They also hold back issuing stocks to employees. This is often done when the company is going through important events, to avoid insider trading and illegal activities.
The main disadvantage of RSU is that the shares are not yours until they are vested, even though they are reserved for you. This limits your control over the shares and the capacity to earn dividends.
Employees may not always have an option to choose one among them. However, if the company allows to do so, the choice must depend on the employee’s objectives. An employee wanting bonus shares in exchange for limited control can opt for RSUs. An employee who wants control in exchange for a certain price can opt for stock options.
RSU settlement is where the shares are vested. They are either paid to the employee in the form of stocks or as cash.
Most companies generally include all forms of equity compensation in the CTC (Cost to Company). However, there can be exceptions where ESOP or RSU are over and above the CTC.