RSUs, NSOs, ISOs: What's the difference?

Equity is increasingly making its way into employee compensation packages, especially in the tech industry. However, not all equity awards are created equally.

Understanding how your benefits work is key to making the most of them and getting cashed out at the end of the day.

Let’s cover what you need to know about RSUs, NSOs and ISOs.

How does employee equity compensation work?

Companies offer equity compensation for a variety of reasons. For one, it allows them to supplement employee salaries without incurring higher up-front costs. Many also believe that giving employees a sense of ownership incentivizes them to stay longer and help grow the company.

Vesting

When your employer grants RSUs, NSOs or ISOs, you won’t receive equity right away. Rather, you’ll typically receive your award in installments as the specified terms are fulfilled in a process called "vesting". These requirements may be time-based, or they may rely on the occurrence of a liquidity event, such as an IPO or acquisition.

Common types of vesting schedules include:

• Cliff vesting: all of your shares vest at once after a specified period of time (ex: you’ll receive 100 shares after four years)
• Graded vesting: your shares vest in portions over several periods of time (ex: you’ll receive 25 shares per year for four years)
• Hybrid: a combination of cliff and graded vesting schedules (ex: you’ll receive 50 shares after two years and 25 shares per year for the next two years)

What are RSUs?

Restricted stock units (RSUs) are a promise from your employer that you’ll receive a specified number of shares upon vesting. RSUs are the most common type of equity award, predominantly granted at big public companies or late-stage startups.

At a public company- RSUs are as good as cash since they can be traded as soon as they're vested. At a private company, RSUs have little to no liquidity - some bigger companies have secondary markets on platforms like Forge ut by and large you'll have few options to sell until you've IPOd.

Typically, your RSU award will be based on the company valuation when you first join.

For example: If you receive $100,000 in RSUs when your company stocks are worth $50 per share, you’ll get a total of 2,000 shares.

Tax considerations

When your RSUs vest, you’ll have to pay ordinary income tax on the total value of your shares. This includes federal income taxes, state and local tax, social security and Medicare. Then, if you hold onto your shares after they vest, you’ll have to pay capital gains taxes on your earnings once you sell.

Some employees try to hold onto their stocks for at least a year after receiving them in order to take advantage of the long-term capital gains rate. However, financial experts advise that you should think about your equity like a cash bonus. If you would spend your bonus on company stock, you should continue holding the shares. Otherwise, you should sell them.

👉 Read next: Should You Sell RSUs as They Vest?

Pros of RSUs

No upfront costs

Unlike other forms of equity compensation, once your RSUs vest, you’ll receive them at no cost. Therefore, there’s no way you can lose money, making them low-risk for employees.

Never “underwater”

Stock options are known as “underwater” when the exercise price is higher than the current market value. This means that they’re worthless, since exercising would result in losing money. However, RSUs are always worth the value of the underlying share. Therefore, unless the company goes bankrupt, they always have some worth.

Fewer decisions required

When RSUs vest, they’re automatically converted into company stock. Then, you’ll be taxed as soon as they vest. Unlike other equity compensation, this doesn’t allow much room for flexibility. However, the lack of choices can also save time and mental energy.

Cons of RSUs

High taxes

Compared to other forms of equity compensation, RSUs are subject to relatively high taxes. Depending on your state laws and income bracket, your RSUs may be taxed at 50% or higher. Since these taxes are due upon vesting, many employees may feel pressured to sell stock to cover them.

Lower upside potential

RSUs are typically granted at successful, well-established companies. Because these firms have already reached a major milestone, they’re unlikely to see the same exponential growth as some early-stage startups.

What are ESOs?

Employee stock options (ESOs) are contracts that allow employees to purchase a certain number of company shares at a specified price. Unlike RSUs, they’re much more common at smaller private companies.

In order to understand how ESOs work, you’ll need to be familiar with the terminology surrounding stock options:

• Exercise price (strike price): the price at which can buy or sell a stock
• Market price: the current price of the stock in the market
• Expiration date: the date by which you must exercise your options

When you first receive ESOs, the exercise price will be set at the current company share price. Therefore, in order to make a profit when you exercise the option, the stock price will need to be higher than it was when you joined the firm.

For example, let’s say you receive employee stock options to buy 1,000 shares of your company at an exercise price of $10. Once your options vest, the market price has risen to $20. You have three options:

1. Exercise the options and immediately sell the stock, making a profit of $10,000
2. Exercise the options and hold onto the stock, hoping that the value will rise further
3. Wait to exercise your options until the expiration date

On the other hand, at the end of the vesting period, the market price may have declined to $5. In this case, your options will be “underwater,” or worthless. Therefore, you’ll have to wait until the market price rises above the strike price before exercising your options.

ESOs can be divided into two categories: non-qualified stock options (NSOs) and incentive stock options (ISOs).

NSO tax structure

Exercising your NSOs will trigger ordinary income taxes, regardless of whether or not you sell the underlying stock. In other words, you’ll pay federal, state and local income taxes, as well as social security and Medicare on the difference between the exercise price and the current market value. Then, when you sell, you’ll pay capital gains tax on the difference between the sale price of the stock and the market value when you exercised the option.

For example: Let’s say that you exercise your NSOs to buy 1,000 shares at a strike price of $10 when the market price is $20. You’ll pay ordinary tax on the $10,000 of profit. Then, you hold onto the shares for one year until the market price reaches $30, at which point you sell them all. Once you sell, you’ll pay long-term capital gains tax on the most recent profit of $10,000.

Pros of NSOs

High upside potential

Because NSOs are typically distributed at early-stage companies, employees have the opportunity to cash in on significant gains. In some cases, successful startups may end up earning life-changing profits for fortunate employees.

Mostly restriction-free

Because NSOs come with few tax privileges, they’re also subject to fewer limitations. Therefore, employees can make the right decision based on circumstances without worrying about complying with guidelines.

Cons of NSOs

Few tax advantages

Similar to RSUs, gains from NSOs are subject to ordinary income tax. Therefore, taxes can eat up over half of some employees’ profits. Additionally, many option holders may need to exercise their options and sell the underlying stock in order to pay taxes.

Significant costs upon exercise

Although NSOs allow employees to buy company stock at an advantageous price, they still require a significant investment. Some employees even seek out loans or pull out savings in order to cover the initial cost.

ISO tax structure

Compared to NSOs, ISOs allow employees significant tax benefits when exercising their options. Unlike NSOs, ISO holders don’t need to pay taxes upon exercising their options. Instead, they’ll be able to wait until they sell the underlying stock, at which point they’ll be taxed on the difference between the exercise and sale prices at the capital gains rate.

These tax advantages come with a few key limitations:

• For one, only $100,000 of ISOs can vest per year.
• Additionally, you need to hold them one year from the exercise date and two years from the grant date in order to unlock the long-term capital gains rate.

Pros of ISOs

High upside potential

Just like NSOs, ISOs usually make their way into up-and-coming firms with high growth potential. Therefore, some can prove to be a lucrative investment for employees.

Tax advantages

ISOs offer a much more favorable tax structure than other forms of equity compensation, including deferred taxes and lower rates. These advantages can help employees retain a much larger portion of their earnings.

Cons of ISOs

Significant costs upon exercise

Although exercising ISOs doesn’t trigger taxes, it does require an investment to purchase the stocks in the first place. Depending on the exercise price and the number of shares, this can be a significant cost for some employees.

Stricter limitations

In order to take advantage of the tax benefits of ISOs, employees must follow certain rules such as minimum holding time. While this can save them a lot on taxes, it may also incentivize them to hold onto shares on the decline, leaving them worse off in the end.

How do the three compare?

While RSUs, NSOs and ISOs are all forms of equity compensation, they have their fair share of differences. RSUs tend to be a lower-risk asset, offering great certainty but lower upside potential. On the other hand, ESOs may yield high gains if the company succeeds or end up worthless if it fails.

When it comes to NSOs vs. ISOs, incentive stock options tend to be more favorable overall due to their tax benefits. However, it’s important to be mindful of the limitations, as well as the potential of triggering the alternative minimum tax.

Most companies will offer a single type of equity compensation to their employees, so it’s unlikely that you’ll have to make a choice. However, knowing the pros and cons of each can help you compare job offers and make the most of your assets.