When companies offer equity as part of employee compensation, it can take the form of Restricted Stock or Restricted Stock Units (RSUs). RSUs represent a promise of stock rather than actual shares.
What are Restricted Stock Units (RSUs)?
RSUs represent a promise or grant to provide stock to an employee as part of their compensation. Companies can offer Restricted Stock or RSUs, but most prefer RSUs for their flexibility.
To prevent employees from taking stock or RSUs and immediately leaving the company, both are typically subject to a vesting schedule that specifies when the employee will actually receive the shares. Vesting schedules require the successful completion of a certain term of service and/or specified work performance.
How Do RSUs Work?
RSUs can come with various restrictions. Some are subject to only a vesting schedule and may be referred to as ‘single-trigger’ RSUs. A vesting schedule might, for example, be a three-year arrangement that issues a specified number of shares upon the completion of a certain period of service. An employee who leaves the company prior to a vesting date forfeits the remainder of their share allocation.
Other RSUs, called ‘double-trigger’, may include additional conditions that must be fulfilled. An additional requirement might be that the employee successfully completes a certain work assignment such as developing a new product or writing a software program, in order to receive shares.
Additional restrictions might have other performance requirements or limits on the sale or transfer of the stock. The RSU contract may also dictate whether the employee gets actual stock or the cash equivalent.
RSU Vesting Schedule
A vesting schedule requires the employee to work for a certain period of time to enjoy the full value of the grant.
Different types of vesting schedules include:
- Graded vesting: Certain percentages of the total grant vest as specified periods of time elapse.
- Cliff vesting: 100% of the grant vests upon the completion of a stated service period.
- Performance-based vesting: The stock allocation is tied to a product or service launch.
- Liquidity event vesting: An event such as an IPO, merger, or acquisition triggers some or all of an RSU grant.
Employment termination generally calls for future allocations to cease, but there can be exceptions built into the grant for circumstances such as death, disability, or retirement.
Sale of RSUs
RSUs are granted directly to individuals and cannot be sold or transferred to anyone else. Once shares become vested, they become transferable. If the shares are publicly traded, they can be sold at any time. If the employer is still a privately-held company, RSU-granted shares may not be sold as easily since there is no readily available secondary market.
Taxes on RSUs
When RSU shares vest, they become the property of the recipient and are considered to represent taxable compensation. At that time, the value of the shares is recognized as ordinary income and taxed accordingly. Thus, if 5,000 shares vest and the current share price is $2.00, an income of $10,000 is recognized and ordinary income tax is due.
The company can determine the value of the shares based on their par value or the value represented by the most recent financing round.
Paying income tax on a stock grant can be problematic for an employee since they would have stock rather than cash compensation and they may not wish to liquidate the stock. Some employers allow the employee to offset part or all of their tax liability by surrendering an equivalent number of shares granted. Other ways to deal with the tax liability include filing 83(b) or 83(i) elections.
Filing an 83(b) election with the IRS allows the recipient of Restricted Stock to pay income tax on the shares when granted rather than when received. An 83(b) election, which must be filed within 30 days of the initial grant, will bring on the income tax liability much sooner, but it will also generally mean that the tax burden is lower since the value of the stock at the time of grant will likely be lower than it will be at the time it is later received.
Importantly, however, an 83(b) election is not available for RSUs, which are taxed under a different part of the tax code.
An alternative to the 83(b) election is to file an 83(i) election within 30 days of receiving the shares if the grant permits this. This election defers from federal taxes the income recognized at vesting for 5 years, or earlier if the company goes public or is acquired. Social Security, Medicare, and any state tax may still be due at the time of vesting.
Two qualifications for 83(i) eligibility are:
- The grant must specify that the RSUs are 83(i) eligible.
- The company must make these qualified grants to 80% of eligible employees in the same year.
When ultimately selling granted shares, short or long-term capital gains or losses are recognized, based on the sale price of the stock less the price at which the recipient received the shares upon vesting.
Note: Information for this section was provided by Bruce Brumberg, Editor-in-Chief of myStockOptions.com, a website with content and tools on all types of equity compensation.
Tip: Due to the rules and complexities of 83(b) and 83(i) elections, employees should consult with their tax professional for the latest IRS rules and to determine the most beneficial course of action in their situation.
Why Do Companies Grant RSUs?
Startup and early-stage companies need to bring in employees, contractors, and other workers to build their operations before sustained revenue is available to pay competitive salaries. Some of the money necessary to build talent teams may come from investors or venture capital, but it is common to supplement that with a stock incentive as well. A promise of stock is also helpful in attracting talent away from other jobs and compensating employees for the risks inherent in working for startups that may not necessarily survive.
Pros & Cons of Owning RSUs
- Appreciation: Stock in early-stage companies can potentially realize significant appreciation.
- Ownership stake: Recipients get a stake in the company and its future at a time when their own efforts might enhance the value of that stake.
- Partly tax-deferred: If the stock does appreciate significantly over time, the gain from the original grant price will not be taxed until the stock is sold.
- Subject to forfeiture: Leaving the company before being vested results in forfeiting non-vested shares.
- May have no value: Early-stage companies have a higher risk of insolvency.
- Taxed as compensation: The value of the shares will initially be taxed as compensation when received (or when granted if filing an 83(i) election), even if the stock is held and not liquidated.
RSUs vs. Stock Options
Companies may issue stock options to employees in addition to, or instead of, RSUs. The table below illustrates the main differences between the two:
More complex to value—involves exercise prices and expiration dates
Easier to understand—employee knows what the value of their grant is and when they'll receive the shares
Funds required to purchase
Employees provide funds to purchase the stock at the predetermined exercise price
Result in stock grants that require no funds from the employee
Have value only if the stock price is more than the option’s exercise price
Have value based on the stock price at the vesting date
Have an expiration date, requiring the recipient to take action by that date to purchase shares
Once issued to the recipient, they become shares with no expiration date
RSUs represent a way for early-stage companies to attract talent away from established firms when they may not yet be able to pay competitive salaries. At the same time, RSUs represent a unique and potentially lucrative benefit to employees who are willing to take the risks involved with a startup.
This article was written by
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