RSUs vs. ISOs: Equity Compensation 101

Chances are, if you’ve reached a point in your career where your employer has granted you Incentive Stock Options (ISOs) or Restricted Stock Units (RSUs), you’re doing great. Both ISOs and RSUs are reserved for highly valued members of a company, people that organizations really want to retain for a long time. So, first things first, nice work!

Second things second, there’s opportunity here — and understanding how they work will help you realize the opportunity. This can be a tricky process, and handling your grants properly depends on a range of factors. This includes the technical side — your existing assets, debts, and tax bracket — as well as the personal side, including the risk you’re comfortable with and your financial goals. Wouldn’t it be nice to finally buy that house you’ve been looking at on Zillow? (retire early, buy a home, start a family)?

In both cases, it’s important to consider what it’s worth to you to stay with the same company for an extended period of time. If you absolutely love your job, or if the magnitude of upside is sufficiently compelling, your equity compensation plays a big role in how you plan your life. You have all this money on paper, but how are you going to turn it into material goals? Should you hold onto the cash or fund a Mega Backdoor Roth?

Fortunately, this is the kind of process that I’ve dedicated my life to helping people optimize. I’ve spent lots of time developing a deep understanding of each option (pun not intended, but embraced), and collaborating with clients to help develop equity compensation strategies that are right for them. 

In this article, I’m going to outline the essential properties of RSUs and ISOs, including how they work, potential upsides, potential downsides, and how to handle each. Whether you work for a large, established company, or a startup on the verge of an IPO, I hope you find the information illuminating. Of course, if the article leaves you with questions, please don’t hesitate to reach out!

Not sure where your company stock price is headed? Hoping you can buy a home or retire early? Schedule a demo of our scenario testing software.

What are Restricted Stock Units (RSU)?

In the simplest terms, RSUs are units of stock that, according to a vesting schedule (a period of time, or upon the completion of certain performance milestones), an employer administers to an employee as income. That is, on the shares’ vesting date, the grantee receives the full value of the shares. As long as the company’s shares have value, RSUs always result in some amount of income upon vesting. ISOs are a bit more complicated, but we’ll get to them in a second. RSUs are more common at larger, established companies — if you work for a giant tech company, chances are, you’re getting RSUs.

Example: John works for Company X. In addition to his salary, Company X grants John an RSU plan in which he will receive 4,000 total shares in the company, administered 1,000 per year for four years (this is a very simplified model — after the first year, actual vesting schedules often operate on quarterly or even monthly bases). Each of these years is its own vesting date; at the end of four years, the grant is fully vested. If, after year one, a share in Company X is worth $100, John would get $100,000 in income. Then if, by year two, a share in Company X is trading at $120, John would receive $120,000 in his next 1,000-share payout.

But let’s say the first vesting increment happened during the very early days of COVID-19, when the market temporarily tanked and stock prices were uncharacteristically low. This could have created an opportunity for John to not only recognize less ordinary income upon vesting, but by holding those shares for the next year, he would be taxed on the appreciation at the more favorable long-term capital gains rate instead of the higher ordinary income tax rate. In short: He could theoretically have saved a lot in taxes.

John’s situation is pretty straightforward — yours might be more complex. For instance, you may have multiple grants with different vesting dates. It’s also important to be mindful of tax withholding and lockup periods. In some cases your employer will withhold estimated tax from your paycheck, but often this won’t be enough to cover the bill. You could even be subject to inadvertent underpayment penalties and/or a surprise tax bill when you go to file your return. With proper planning, this withholding can be adjusted accordingly prior to the vesting date.

Generally, RSUs are the most straightforward type of equity compensation. Most people opt to sell them immediately upon vesting, realizing a healthy extra chunk of income. But depending on how much cash you have, your family circumstances, your homeownership situation, and more, it could make sense to wait a certain period before cashing out.

This is where I come into play. I can help you envision a wide variety of possible financial futures, and tell you exactly how different RSU moves will impact your ability to realize your goals. Through sophisticated technology which allows us to project decades into the future, years of experience handling similar cases, and a thorough comprehension of who you are and what you care about, I will always help you make educated choices.

Now, buckle up, because RSUs’ cousins — ISOs — are a little bit trickier.

Okay. I’m ready. What’s an Incentive Stock Option (ISO)?

(If you’re still with me at this point, I applaud you. I know this is a lot to take in, but by studying up, you’re putting yourself in a much better-educated position than many.)

ISOs are a little bit more complex than RSUs, so here’s a quick index of terms to reference as you read:

• Grant Date — the date on which a company issues ISOs to an employee

• Vesting Date — the date, usually starting one year after the grant date, on which an ISO bearer may legally exercise their options, buying company shares at the strike price (defined below)

• Vesting Schedule — a schedule by which an employee receives their ISOs

• Offering Period — the length of time after the grant date in which an ISO bearer may exercise their options (usually 10 years for ISOs)

• Exercise Date — the date on which an ISO bearer chooses to exercise their options

• Strike Price — the company’s share price on the grant date; the price at which the company permits the grantee to buy shares on the exercise date

• 409A Valuation — an appraisal conducted by an independent third party that determines the fair market value (FMV) of stock for companies which have not yet gone public

• Blackout Periods — times when an employer prohibits employees from exercising options or selling shares of stock; stringency depends on the employee’s role of the company

An ISO is a corporate benefit an employer gives an employee which gives them the right to buy stock in the company at a later date, for the price of the stock at the time of the initial agreement. The value of ISOs is based on the difference between the company’s share price at the time of the grant and the company’s share price when the options vest. ISOs are favored by early-stage companies — often on the verge of IPO — on the brink of considerable scaling.

Example: Marsha is a software engineer for XYZ Cloud Corporation, a promising tech startup poised to go public. On June 1, 2019 (the grant date), XYZ granted Marsha 5,000 ISOs when the share price was $5 — a total value of $25,000. In exactly four years, after XYZ has gone public, when Marsha’s ISO vests, the share price has risen to $20 — a new total value of $100,000. Marsha opts to exercise her ISOs on June 1, 2023 (the exercise date), buying her shares for $5/share (the strike price) and selling them for $20/share, realizing a profit of $75,000.

Now, imagine that XYZ’s IPO hadn’t gone as planned, and on the vesting date, their share price had remained at $5. Marsha could still exercise her option on this date, buying her shares for $25,000, but it wouldn’t make sense for Marsha to sell her shares, because she would realize no profit. Fortunately, Marsha would still have a 10-year offering period in which she could legally exercise her options before they expired. So if, in nine years and 364 days (May 30, 2032), XYZ’s share price miraculously rose to $100, Marsha could sell her shares at that time for $500,000 and make $475,000 of profit.

In both scenarios, Marsha was fortunate; in the years between the grant date and the exercise date, XYZ’s share price rose. That doesn’t always happen. Growth is never guaranteed. This is the risk inherent to ISOs: If the company’s share price doesn’t rise before the option expires, the ISOs are “underwater” — worthless. Or, if the share price does rise, but the ISO grantee elects to await further growth before exercising their option, the share price may plummet, obviating any potential gains that the bearer could have reaped had they sold when the price was high.

As with RSUs, there are a number of factors to consider as you plan out when to liquidate the shares granted to you, all with different tax ramifications. Once your options vest, you have to choose between buying your shares with your own cash or doing a cashless exercise, in which you borrow money to buy your shares and then sell them right away. Cashless exercises may sound easier — and, for people with limited cash on hand, they are, but cashless exercises are taxed at a higher rate than they would be if the shares were purchased with cash and held for longer than one year.

So, if you’re flush with cash (and bullish on the company), it probably makes more sense to buy the shares outright, and then figure out whether to sell them all right away, hold them all for a period of time, or sell them incrementally over a series of years. Again, all of this depends on the tax consequences, your financial circumstances, your spending goals, your personal preferences, and more. 

This, again, is where I deliver value to my clients. I know how much cash you can currently access. I know how much risk you’re comfortable with, and I can give you a clear sense of how risky your different options are. Perhaps most importantly, I have an exhaustive knowledge of the tax consequences of various decisions, and so I can make choices easy for you. If leveraged properly, ISOs can be very remunerative. I can help you maximize their potential.

Crossing The Finish Line

Pat yourself on the back, because you’ve just completed lesson #1 in the two most common equity compensation models. As you can see from the abundance of technical language and the brainpower it takes to understand the intricacies of RSUs and ISOs, achieving a thorough comprehension of equity-based compensation is no mean feat. 

Determining how best to handle your RSUs/ISOs depends on much more than a solid comprehension of their different features. It means thinking deeply about your life goals — whether you want career flexibility, are planning to have children, trying to save up for a home, or thinking about retirement. With careful planning, you can come up with a model fitted perfectly to your values and goals.

As you wade through all of this information, remember, I’m always here to help. While some people look at RSUs and ISOs and just see two more irritating acronyms, I have a wealth of training and experience to fall back on, and know how to apply my hard-earned knowledge to your situation. By helping you plan well today, I’ll be able to help you live well tomorrow.

For more information on how our firm can help optimize your future, or to schedule a free, informal call to discuss your financial planning needs, please don’t hesitate to reach out! Schedule a complimentary meeting. On the West Coast? No problem, evening hours are available.

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Making the most of your equity awards