What is the Difference Between RSU and ESOP
Offering employees stock options is an excellent talent retention strategy but take the time to understand the difference between RSU and ESOP. Restricted Stock Units (RSUs) and Employee Stock Option Plans (ESOP) are quickly becoming popular with startups having limited capital.
You can offer equity as part of compensation packages to not just reward them for their hard work. But, also to incentivize them to stay longer with the company and invest in its continued success. While the fundamental principle behind RSUs and ESOPs is the same, their terms have a few differences.
Understanding How ESOPs Work
ESOPs award employees the right to buy shares at a future date at a specific rate. Your company can determine the share price at which they can exercise this right (predetermined price). ESOPs include a vesting schedule condition, or the duration the employee must work in the company.
This provision ensures that valuable equity does not go to short-term employees. From the recipients’ perspective, they get stock at prices below the fair market value on the vesting date. Founders may choose to award the ESOPs per a staggered, pre-determined schedule.
Let’s look at an example.
Your employee receives the option to buy 2,000 shares in your company in January 2018. He can exercise this right to buy 500 shares per year starting from January 2020, priced at $100 per share.
If the current market value is $150 per share, the employee stands to make a profit. However, if the share price is lower than $100, he has the option to delay his purchase until market conditions improve. At the same time, ESOPs come with an expiry date. The offer stands for a fixed time and lapses if the worker chooses not to exercise the option.
Some startups may choose to offer ESOPs in blocks. For instance, the employee can get 25% of the ESOP in the first year and another 25% in the second. Once the employee remains with the company until the third year, they can exercise the remaining 50%.
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Understanding How RSUs Work
Awarding and exercising Restricted Stock Units (RSU) is more streamlined than ESOPs. This form of equity incentive does not come with predetermined pricing. Company owners offer RSUs when employees meet certain conditions, such as remaining for a specific time or achieving certain goals. This is one of the key differences between RSU and ESOP.
RSUs can be performance-driven, and recipients can exercise the option within a fixed vesting period. If the vesting period is five years, the employee is eligible to receive the stock only after they complete five years with the company.
Let’s assume you’ve allocated 500 shares to an employee. At the end of the vesting period, they have the option to purchase the shares. Or they can get the cash equivalent depending on the current market value. Some companies reserve the right to make the final decision, while others may allow the employee to select their option. Like ESOPs, you can choose to award a fixed percentage of the allotment of shares every year.
Types of Restricted Stock Units
RSUs can be of three different types:
- Time-Oriented RSUs – Employees must remain with the company for the duration of the vesting period. After this time frame, they can unlock the RSUs and sell as needed.
- Milestone-Oriented RSUs – These RSUs are incentive or performance-driven. Employees must achieve the goal to get their stock. For instance, a sales target.
- Time-Oriented and Milestone-Oriented – Meeting both, the vesting period and milestone is a condition for selling the stock.
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Difference Between RSU and ESOP – Let’s List the Factors
Before issuing an RSU or an ESOP, you should take the time to understand the difference between RSU and ESOP.
| Differentiating Factors | RSU | ESOP |
| Types of issuing companies | Young startups with limited operating capital but high growth potential | Startups and, established companies |
| Types of Issues | Employees receive stocks. | Employees get the option to purchase stocks. |
| Conditions for allotment | Employees get RSUs when they complete a fixed tenure or accomplish a preset milestone. | Employees can buy the shares after a predetermined interval at a predetermined price. |
| Optional or Mandatory | Employees receive the shares from the company mandatorily. | Employees have the option to buy the shares without any obligation. |
| Voting rights | RSUs don’t carry voting rights. | ESOPs award voting rights to the shareholders, upon exercise. |
| Dividends | RSUs are not eligible for getting dividends. | ESOPs can earn dividends like any other stock, once the employee exercises them. |
| Other rights | Restricted shareholder rights | Complete shareholder rights awarded after exercising the rights. |
| Limitations | Tenure or milestone | Completing the vesting term. |
| Nature | Shares or the equivalent of the current market value of the fixed allotment | Shares in the company |
| Variations | Incentive Stock Option (ISO) or Non-Qualified Stock Options (NSO) | Restricted Stock Units and Restricted Stock Awards |
| Exercise Price | No pricing is determined, and the stock is free of cost. | Employees must pay the exercise price to receive the stock. |
| Risk factor | Minimal risk since employees receive stock priced at the fair market value or FMV. The stock may lose value only when the company goes out of business or its performance declines. | More risk since the market share value could be higher or lower than the predetermined price. |
| Settling post-vestment period | Employees can defer the settlement for taxation purposes if all other conditions are met. | Employees have the discretion to exercise their rights as and when they want to. |
| Earning potential | Employees get stock without investing anything. Getting cash is also an option. | Employees must pay the exercise price to purchase the shares. If they don’t have the funds, they may lose the opportunity. |
| Date of expiry | RSUs don’t expire and are available when the employees meet the conditions. | ESOPs carry an expiry date, and the option is only available for a fixed time. Employees exiting the company before the vesting schedule may have to cede their rights. Other terms and conditions can also apply. |
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Taxation of RSUs and ESOPs
From the taxation treatment perspective, there is no difference between RSU and ESOP. Both stock options attract similar taxes per the regulations of the Income Tax Act, 1961.
When Receiving Stocks
When you allot RSUs to your employees, they’ll pay income tax on the market value of the shares on the vesting date. That’s because the stock is part of their income or compensation package. The tax treatment for ESOPs is different. Here’s how the tax applies.
Fair Market Value of the Shares – Predetermined Value of the Shares = Profits x Prerequisite Tax Rate
Employees calculate tax on the market value of the shares on the date when they purchase the stock. Many companies may also deduct tax at source and remit the withholding taxes or TDS to the government. In that case, the employee can claim the tax credit on their returns.
When Selling Stock of a Listed or Unlisted Company
The applicable tax rates may depend on each country’s tax regulations and other laws, and your employees must comply with them. For example, if your company is listed on a registered stock exchange, employees are liable to pay taxes when they sell the shares.
In India, short-term capital gains tax (STCG) is applicable only if the employees hold the stock for less than 12 months. If they hold the stock for more than 12 months, they won’t have to pay any taxes.
If your company is unlisted, the tax treatment changes. Capital gains attract taxes at 15% or per the employees’ income tax slab if the holding is less than one year. But, if the holding period is more than 12 months, the tax rate is 20% with indexation benefits.
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In Conclusion
Awarding RSUs and ESOPs is a practical way to reward employees for their work and incentivize them to stay longer. Employees receiving stock from their company must evaluate the difference between RSU and ESOP. Although both stock options are beneficial, they’ll want to assess the company’s future growth prospects. They’ll also want to determine the risk factors involved, especially when purchasing ESOPs, because they’ll invest money into the stock.
If the company projects assured growth and development, the employees may hold on to the stock and bank on rich returns. However, like all other stocks, the investment does come with a risk factor and is subject to the vagaries of the stock exchange.
Your employees may also base their decisions on whether they intend to remain with the company for an extended time. Or, if they prefer liquid cash and take-home pay or lock their compensation into stock. Keep these factors in mind when working out the kind of stock you want to issue.
