(Podcast and video to follow)
Blog RSUs vs. NSOs
- More companies are giving employees a choice between NSOs (Non-Qualified Stock Options) and RSUs (Restricted Stock Units).
- There is no right or wrong choice. It is about understanding the pros and cons of each and how they fit with your goals, risk tolerance, and personal financial profile.
- RSUs are easier to understand, manage, and most often considered less risky, with less downside.
- NSOs are more complex, harder to manage, and riskier, with more downside.
- Generally, you will receive more NSOs than RSUs.
- It is often helpful to breakout your considerations into tax and investment issues.
Companies are increasingly allowing employees to choose between NSOs, RSUs, or some combination thereof. Usually, the employee can choose between 100% of NSOs, 100% of RSUs, or 50%NSOs/50%RSUs.
We all love choice. But sometimes, too many choices can complicate things and cause unwanted stress. The NSO-RSU choice can give many employees a few sleepless nights. There is a reason Costco has a fraction number of SKUs compared to Walmart. In the case of NSOs and RSUs, the choice really is a good thing.
The company sets up the choice, and as you might guess, the company is indifferent to your choice. While the company may be indifferent about your choice, you should not be. What is right for you and your family is probably dramatically different than that of the company.
Why is there a different amount awarded for each type of equity compensation?
Why do they offer more NSOs? Generally, the ratio of RSUs vs. NSOs is decided by using an equation called the Black Scholes pricing model. I’d like to say I remember every nuance of the model from the CFA tests, but that was too long ago! While not perfect, the model attempts to assign a value to options like the NSOs, so the RSUs and NSOs are of equal value at the time of the grant.
The reason for more NSOs? Because they are riskier and have a better chance of having a value of zero. RSUs have almost no chance of going to zero. Anytime something has a higher risk, you discount it. If you discount it, you need more of them to equal something with a certain value, like the RSUs.
So what does this mean in real life? The CFA test can only get you so far! If the underlying stock price is declining, you are often better off having RSUs. If the stock price is increasing, you are better off having NSOs. If the stock price drops below the strike price of the NSO, the option will have a value of zero.
A common ratio for an NSO/RSU grant is 4:1 (usually between 3 and 5 to one). As an example, you might be able to choose from the following:
- 100% NSOs
- 50% NSOs & 50% RSUs
- 100% RSUs
- The current market value of our pretend company stock is $100
- The strike price of the NSOs is $100
With clients it is often helpful to run thought possible outcomes, possible scenarios:
- NSOs provide the most upside and downside
- RSUs most likely will always have value
- With the security of RSUs comes less upside
- The 50/50 option gives you a little of both worlds
- To exercise the NSOs, you will have to pay the strike price (in this case, $100)
A major cost that is often overlooked with NSOs is the cost to exercise the option. The option is awarded to you, but to exercise the option requires you to pay the strike price for the share of stock. Most often, when you get the statement from your employee compensation statement, it will automatically subtract the cost of the option from the stated value. So, if the option has a strike price of $100 and the stock is trading at $150, it will show a $50 per-option value.
This cost could play into your NSO vs. RSU decision. With RSUs, there is no upfront money, no strike price. You simply take possession of the shares at vesting. As with exercising the NSOs, it’s a taxable event, but you don’t have to “buy” the shares.
As you might guess, concentration risk is very common for those with equity compensation. It is not uncommon to see families with 20%+ of their net worth in some form of their company stock. This problem is even more compounded by the fact that their income, health insurance, and other benefits depend on the health of their company.
When it comes to the choice between RSUs and NSOs, if you do not like or do not have the ability to take on the concentration risk, then RSUs may be the better option. You can tell by the chart above that RSUs are the less risky choice.
If you are comfortable with or may even want to have concentration risk, then the NSOs may be the better choice. Because NSOs can be considered “leveraged” and have a greater upside and downside risk, they can be seen as intensifying the concentration risk.
Personal Risk Tolerance
The ability to take on risk should be a factor in any investment decision, especially equity compensation. Your ability to take on risk is affected by things like the size of your emergency fund. Are you a one-income household? What other assets do you have? Do you have disability and life insurance? What goals, like college or retirement, do you have?
The ability to take on risk has to do with the numbers and how quickly you would have to access the funds. And when it comes to concentration risk, can you reach your goals and live a good life if your company stock never comes back?
I have some families that have great personal balance sheets, good jobs in different industries, good emergency funds, and plan on working and saving for another 15+ years, but their concentration risk is so high that they have to invest very conservatively with their other assets.
The question I would like for clients to answer is if the stock price dropped 35%, the stock market dropped 25%, and you lost your job, how soon would you have to access your investments? And the next question I ask is how well would you sleep at night if this happened? This has to do with the willingness to take on risks.
Clients don’t spend nearly enough time exploring their willingness to take on risk. Engaging them in the conversation is often difficult, even with our fancy online questionnaires. When looking at the willingness and equity comp, it is good to ask, what if ½ of your equity comp value went away and did not come back? Would you be ok with that? Could you sleep at night? How much would it bother you, even if most of your goals could be met?
If you’re willing to take on risk is low, choosing RSUs may be the way to go. As you saw with our chart above, there is a lot less variance in value with RSUs than NSOs. If your willingness to take on risk is high, the NSOs may be more attractive.
Please be very honest about your willingness to take on risk. Don’t wait until the thunderstorm hits to change the batteries in the flashlights. Preparing in advance will keep bad things from happening.
If you need aggressive returns to reach your goals, NSOs would most likely be the best choice. If your return needs are less, but you need an increased probability of having a certain amount, like for your kid’s college, then the RSUs might work best.
Of course, if the timing of cash flow is an issue, which is often the case with goals, especially goals like college, then knowing and planning for vesting schedules is a must.
RSUs are easier to manage. You know when they vest, and you will take possession of the stock after paying the tax. The only questions are 1) how much will the stock be worth and 2) do you sell the stock.
NSOs are a little more complicated. Not only is there less certainty of how much they will be worth, but you have two other questions to answer, 1) do you exercise and pay the tax, and 2) if you do exercise, do you sell the shares.
If you are looking for a simpler option and more certainty, RSUs might be the better choice. If you can handle complexity and speculation, then NSOs might be your right choice.
As you can tell, it is not only goals you have to plan around, like with other investments, but also the taxes. Tax planning is far more critical with equity compensation than most other investments.
Everyone knows about tax prep. We either do it ourselves or pay someone else, usually a CPA or EA. But very few do tax planning. For many families, planning is more critical than preparation. Prep is designed to keep you out of trouble with what you’ve already done; planning for the future ensures you have more choices, paying less in taxes and making prep easier.
As a refresher, NSOs and RSUs have similar tax profiles. Both are subject to ordinary income, Social Security, and Medicare taxes. Where they differ is when that tax is due and on what amount.
For RSUs, the tax is due when the units are delivered at vesting. This delivery usually follows a time-based vesting schedule out of your control. When RSUs vest, the total value is taxed at ordinary income rates, with a withholding obligation by the company at a supplemental tax rate of 22% (37% if over $1,000,000 of income). Most companies will net out the shares at delivery to satisfy the tax withholding. For many high earners, 22% won’t come close to satisfying the tax obligation. Avoiding a tax surprise or penalty may require an estimated payment or adjusting a W-4.
For NSOs, tax is due when you exercise your options. When exercised, the spread between the stock’s current fair market value and the option’s strike price is taxed as ordinary income. Shares are often withheld to pay the tax withholding (a sell-to-cover) at a 22% supplemental tax rate (37% if over $1,000,000 of income).
For RSUs and NQSOs, if you later sell the shares at a profit, any gain above the FMV at exercise for NQSOs or above the FMV at vest for RSUs will be long or short-term capital gains, depending on how long the shares have been held since exercise or vest.
Tax planning is easier with RSU because you have few options. But easier does not always mean lower taxes. With NSOs, you can time the exercise during low-income years, filling up tax brackets and paying much lower taxes over the long term.
Other Considerations & Bringing It All Together
By now, you probably understand that NSOs are the riskier higher-upside choice, and RSUs are the lower-risk, lower-upside option (if this blog and podcast did their job!). One concept I also like to get across to clients, depending on where they are on the understanding spectrum, is that a vested NSO has a value that does not show on your account statement. With RSUs, once vested, you must pay the taxes and take possession of the shares.
With NSOs, once vested, you don’t have to exercise. You don’t have to pay the taxes nor take possession of the shares. This kind of flexibility has value.
This flexibility value should not be the primary factor driving your decision; your goals, risk tolerance, taxes, other assets, and overall personal profile should be the major decision-driving factors.
This blog article, and coming podcast, should give you a good base for decision-making. But if you need more, many financial advisors can do a crossover analysis. This type of analysis helps identify the point at which the NSOs and RSUs your company offers are equal, called the “crossover point.” The analysis also shows the effects of time and leverage.
I want to show some examples, but we are over 2000 words, and I’ve been told folks start dozing off after 1500, so we will save it for next time.