Explore how RSUs can be a game changer in employee incentivation and help you to increase Motiviation, Loyalty and reduce staff turnover.
Dominik Konold CEO/founder of Findiy GmbH, specializes in banking and corporate finance. With a background in audit and investment banking, he's a certified Professional Risk Manager and also serves as a lecturer in banking and accounting.
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What Are Restricted Stock Units (RSU)?
How RSUs work
RSUs are granted to employees under a vesting schedule, which outlines when the employee becomes the owner of the company stock. This vesting period can span several years and can be based on time, performance milestones, or a combination of both. They are categorized into two types:
1. Single-trigger RSUs: The vesting condition is typically time-based or milestone-based.
2. Double-trigger RSUs: Vesting requires both time-based and milestone-based conditions to be met. These are common in privately held companies.
For example, if a company grants 300 Units with a three-year vesting period on a yearly basis, the employee might receive 100 shares each year. After the first year, 100 shares vest, with the remaining 200 shares vesting in subsequent years.
Benefits of RSUs for employees
Financial Gain Potential
Employees can benefit if the company performs well, as the value of the RSUs increases with the company’s equity value.
No Upfront Costs
Unlike traditional stock options, RSUs do not require employees to pay an upfront fee to acquire the shares.
Tax Deferral
Depending on jurisdiction, taxes are only paid when the instruments vest, allowing employees to delay taxation until they actually receive the shares.
Incentive for Retention
Restricted Stock Awards encourage employees to remain with the company, aligning their interests with the company’s success.
Drawback and disadvantages of RSUs
Despite their advantages, RSUs have some drawbacks:
No Dividends Until Vesting
Restricted Stock Units typically do not pay dividends until they vest.
Tax Implications
Upon a non-forfeitable status (vesting), the entire value of the instruments is considered taxable income, which could push the employee into a higher tax bracket.
No Voting Rights
Employees do not have voting rights associated with the stock until the shares are granted.
Risk of Forfeiture
If an employee leaves the company before vesting, they typically forfeit the unvested units.
Vesting of RSUs
The
vesting
period is the duration between the grant and when the shares become the employee’s tangible property. The vesting schedule is usually based on time (e.g., the employee must stay with the company for a specified period) or performance goals (e.g., company reaching specific financial milestones).
Once they have vested, employees can either keep or sell the shares. In the case of private companies, employees often have to wait for a liquidity event (e.g., an IPO) to sell their shares. Public company employees can usually sell their vested shares immediately, provided they comply with company trading policies.
RSU tax treatment
RSUs are regularly taxed (depending on the jurisdiction) as ordinary income upon vesting, based on their fair market value (FMV) at the time they vest. Here is how taxation works at different stages:
Grant Date
No taxes are owed when the instruments are initially granted.
Vesting Date
The value of the instruments at vesting is subject to ordinary income tax. Employers typically withhold taxes on behalf of the employee, often by selling a portion of the vested shares.
Selling the Shares
If the employee sells the shares immediately after vesting, there is no additional tax. However, if they sell the shares later at a higher price, they owe capital gains tax on the difference between the sale price and the FMV at vesting.
Tax planning for RSUs
Employees can use different strategies to manage the tax impact:
Sell-to-Cover
Selling a portion of vested shares to cover tax obligations while holding the rest.
Hold for Long-term Gains
Selling after holding the shares for more than a year to benefit from long-term capital gains tax rates, which are typically lower than ordinary income tax rates.
Public vs. Private Companies
Public Company
Employees can usually sell their vested shares immediately, provided they adhere to company trading policies.
Private Company
Employees might have to wait for a liquidity event (like an IPO) to sell their shares. In some cases, companies might allow employees to sell shares in secondary markets.
What happens to RSUs if you leave the Company
RSUs vs. Stock Options
While both RSUs and stock options are forms of equity compensation, they differ significantly:
Stock Options
Give employees the right to purchase shares at a set price. If the price rises, employees can profit by buying at the lower option price and selling at the market price. However, if the share price falls below the option price, the options could be worthless.
RSUs
Automatically grant shares upon meeting vest. conditions, providing value even if the price declines (unless it drops to zero).
RSUs vs. PSUs
RSUs offer more predictability to employees because they know how many shares they will receive once the vesting period is complete. They are generally viewed as a lower-risk form of equity compensation. However, the value of these grants is tied to the company’s stock price at the time of vesting, so the ultimate financial benefit can fluctuate.
Performance Share Units (PSUs)
PSUs, on the other hand, are tied to specific performance criteria, which could include financial targets like revenue growth, earnings per share (EPS), or total shareholder return (TSR). Employees only receive shares if the company meets these predefined performance metrics over a set performance period, often spanning several years.
Because PSUs are linked to performance goals, they are considered a more variable and potentially higher-risk form of compensation. However, they offer the potential for higher rewards if the company performs exceptionally well. PSUs serve as a strong incentive for employees to work toward achieving the company’s strategic objectives.
Key Differences
Vesting Conditions
RSUs vest based on time, while PSUs vest based on company performance.
Risk and Reward
RSUs are less risky but offer more predictable rewards. PSUs are riskier but can offer greater upside based on performance.
Employee Motivation
RSUs encourage employee retention, while PSUs focus on motivating employees to meet specific performance targets.
RSU vs. ESOP
RSUs provide a straightforward incentive for employees, as they do not require any financial contribution on their part. However, the value of the stock is subject to market fluctuations, and the employee may owe taxes on the vested shares, depending on the company’s policies and tax regulations.
Employee Stock Ownership Plans (ESOPs)
ESOPs
, on the other hand, are a type of employee benefit plan that gives workers ownership interest in the company. In an ESOP, companies set up a trust fund and allocate shares of stock to employees, often based on factors like salary or tenure. Unlike RSUs, ESOPs may involve employee contributions and are usually designed to help employees accumulate wealth over time, especially for retirement.
ESOPs are more complex than RSUs, as they often include a range of benefits and rules, such as voting rights and restrictions on selling shares. They can also offer tax advantages to both employees and employers.
Key Differences
Ownership
RSUs involve a grant of shares after vesting, while ESOPs provide a gradual accumulation of ownership.
Vesting
RSUs typically vest based on time, while ESOP allocations can depend on salary or tenure.
Employee Contribution
RSUs require no employee investment, whereas ESOPs may involve employee contributions.