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What Are Restricted Stock Units (RSU)?

RSUs are a form of equity compensation offered by companies to their employees. They represent a promise from the employer to grant a specific number of common stock or their cash equivalent upon meeting certain conditions, such as achieving performance milestones or remaining with the company for a defined period. Unlike stock options, RSUs do not require employees to pay an upfront cost to acquire shares. Instead, employees receive the stock as compensation once the RSU claim gets fulfilled.

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

If you leave your company, you typically retain any unforfeitable RSUs depending on leaver provisions , while unvested grants are forfeited. In the case of double-trigger RSUs, employees may lose shares that aren’t fully vested if the specific milestone conditions aren’t met before their departure. Each company’s agreement outlines the rules regarding unvested RSUs and their expiration.

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.

Bottom Line: A true alternative to stock options

Restricted Stock Units are a valuable form of compensation that aligns employees’ interests with the company’s success. They offer an incentive for long-term employment while providing the potential for financial gain. However, employees must understand the vesting schedule, tax implications, and their options to make the most of their instruments. Proper planning and an understanding of the benefits and drawbacks of RSUs can maximize their value. Check out our Free Trial offer for our platform Incentrium to get the most out of your RSU plan.
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