Introduction
Most employers nowadays provide compensation packages that comprise some uncommon terms like RSU and ESOP, apart from the traditional ones like basic pay, special allowance, EPF contribution, gratuity contribution. Such comprehensive packages are sometimes referred to as “CTC – Cost to Company.”
Hiring managers incorporate RSUs and ESOPs in the CTC in order to recruit and retain personnel. This is especially relevant for startups nearing IPOs. However, many job seekers take such packages without knowing their value or the tax consequences. In this article, we take a close look at RSU vs ESOP debate and specific points one needs to know.
Benefits of RSU and ESOP
As mentioned above, both RSU and ESOP are used as employee retention tools. Apart from rewarding employees monetarily, stock options also ensure employee commitment in the success of the organization. Employees that are invested personally are encouraged to do outstanding work, which can pay off well for the firm as well as the employee.
Nevertheless, acronyms like RSU and ESOP may sound more like alphabet soup than benefits for the uninitiated. You may have the documentation from human resources, but you may still be confused about what these tools are and how they operate.
RSU (Restricted Stock Unit)
Restricted Stock Units are a method for companies to provide equity to employees. The award is “restricted” because it is subject to a vesting schedule, which might be based on the duration of employment or performance goals, and it is limited by additional transfer or sale restrictions that your firm may apply.
There is a vesting schedule for RSUs. This plan is often linked to certain milestones that must be met before RSUs are awarded, such as performance targets or years of service. While an RSU gives an employee a stake in the company’s equity, it is worthless unless the vesting requirements are met. When this occurs, the employee receives the shares (with a percentage retained for income tax). The employee is then free to sell the shares anytime he or she wishes unless there are transfer limitations.
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How do RSUs work?
Assume you join a firm on 1 April 2022, and you are assigned 100 RSUs on 10 April 2022. If the corporation specifies that the RSUs would vest in four 25% tranches over four years, the first tranche of 25 stocks will be available for sale/holding on 10 April 2023. The remaining RSUs will then vest at 25 stocks apiece on 10 April of the following years.
The award date is the date on which the RSUs are assigned to you. Even if you have been issued RSUs, you cannot sell them right now. Every year, a specific number of stocks (also known as tranches) become available for sale. It is known as the vesting of shares, the price of the stock on that day is known as the vesting price, and the date is known as the vesting date. After vesting, you can either keep the stock or sell it.
ESOP (Employee Stock Option Plan)
Employee Stock Ownership (Options) Plan has a history dating back seven decades. Louis O. Kelso, a political economist, and corporate lawyer best known as the Father of the Employee Stock Ownership Concept pioneered an unorthodox type of ownership in the 1950s.
The word “ESOP” refers to a collection of incentives or investments intended for workers of a business. In precise Company Law terms, it is an option granted to full-time directors, executives, or employees to subscribe to the company’s securities at a future period but at a specified rate. As previously said, it is an innovative method of motivating, rewarding, remunerating, and retaining people. In this manner, employees are given partial ownership in the firm.
Most large firms in India, particularly those in the IT sector that are listed outside of India, provide employee stock option plans (ESOPs). Like RSUs, ESOPs are also used as a tool to retain human resource talent. While both RSU and ESOP work side by side in retaining employees, a major facet of the RSU vs ESOP debate is that the latter are usually issued at a discount to the prevailing market price in order to make it attractive for employees.
When it comes to the regulatory aspect of ESOPs in India, a number of statutes must be studied and kept in mind, including the Company Law, Income-Tax Law, Securities Laws, and Foreign Exchange Regulations.
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How do ESOPs work?
Assume you join a company on 1 April 2022, and your company offers you the opportunity to acquire 100 stocks on 1 October 2022, at a price of INR200 per share. This is against the market price of INR300 per share and with a vesting period of 1 year. So, on 1 October 2023, you have an option to acquire the shares at a committed price of INR200 per share. Depending on the prevailing share price, this option may or may not be exercised.
The day on which you are offered this option is known as the “grant date.” The day on which you exercise the option is known as the “exercise date” and the price payable by you is known as the “exercise price.” As mentioned above, exercise price is mostly lower than the market price. In case of exercise price being higher than the market price, there is no incentive for an employee to exercise the option. The selling window for such bought equities is similarly limited. Every year, a specific number of stocks (also known as tranches) become available for sale.
Difference Between ESOP and RSU
| ESOP | RSU |
| An option to buy company shares at a predetermined price | RSUs are granted directly by the company |
| Employee chooses when to buy stock | Shares are transferred as soon as they are vested |
| Cost is calculated as follows: Exercise price X number of options exercised |
Employee bears no cost |
| Optionality – Employees exercise ESOP only when market price is greater than exercise price | No optionality in RSU since there are no costs for employees |
| Tax is applied when employee chooses to exercise shares | Taxed as soon as vested |
ESOP vs RSU – Which one is better?
There are advantages and disadvantages of ESOPs and RSUs, thus making the decision between the two difficult. In general, it comes down to the fact that RSUs are less risky for employees because there is no cost associated with obtaining the shares. On the other hand, ESOPs have a cost and it may lead to losses for employees in the long term if stock price moves down after vesting of shares. This is a major difference between ESOP and RSU.
In general, RSUs give protection that stock options do not provide to employees. If the share price of your company falls below the exercise price, your options will lose value, and the investment would be worthless. An RSU, on the other hand, preserves its worth from start to finish although its value may diminish. Moreover, there is no upfront investment by the employee in case of RSUs. The only way for RSUs to become worthless is the company going out of business. This scenario is less likely than a company’s shares losing money over the years it takes to get vested.
If an employee has to choose between RSU and ESOP, the former is a much better choice. However, bear in mind that you probably won’t have an option receiving either as companies usually have just one of these two. Before you decide on your total compensation package, it’s critical to understand what you’re being provided and how it functions.
We hope we were able to help you understand the key difference between ESOP and RSU and also pick winners in the ESOP vs RSU debate.
