Restricted Stock Units (RSUs)

How Restricted Stock Units Work (Step-by-Step)

RSUs, shorthand for “restricted stock units”, offer the holder the right to receive a pre-determined number of shares in the employer’s equity.

RSUs are “restricted” because the distribution of the shares to the recipient is subject to a vesting schedule.

More specifically, the issuance of the award is conditional on meeting certain vesting requirements:

• Time-Based RSUs: The employee is required to reach specific date milestones, i.e. remain employed by the issuer until a certain date. In a graded vesting schedule, the RSUs vest by a set percentage each year, whereas in a cliff vesting schedule, the RSUs vest entirely at once in a specified year.
• Performance-Based RSUs: The employee must satisfy performance-based targets, which most often consist of KPIs tracking individual productivity (or subjective performance reviews by management).
• Event-Based RSUs: The distribution of the RSUs could also be contingent on certain events, such as the issuer undergoing a liquidity event like an initial public offering (IPO).

Until the conditional provisions for the RSUs to vest are satisfied, the recipient is unable to actually collect the shares. Thus, employees granted RSUs must understand the contractual clauses stated in their award and the risks of not receiving the compensation.

For instance, suppose an employee failed to fulfill their obligations or abide by the terms set under the employment agreement, such as violating a non-disclosure agreement (NDA). The breach of the employment contract and subsequent termination of said employee would cause the vesting of any potential RSUs to stop in most, if not all, cases.

Restricted Stock Units (RSUs): Vesting Schedule and Distribution

On the date on which the RSUs were originally granted, the employee does not immediately receive any shares in the issuer’s equity.

Instead, the receipt of the shares is predicated on the formal vesting schedule and distribution plan, which are each designed by the company’s upper-level management to ensure there is a rigid corporate structure where incentives are closely aligned among all employees.

• Vesting Schedule: The vesting schedule states the date on which the RSUs were awarded and the dates on which the shares vest, assuming the predefined conditions are met. The award amount is also stated—which determines the quantity of share units earned—and most importantly, the vesting requirements are outlined here.
• Distribution Schedule: The distribution schedule specifies the form of payment (e.g. stock-settlement, cash-settlement, a dividend of equivalent value) to be issued, as well as the timeline in which the proceeds would be paid out, i.e. the specific dates of distribution.

Once the conditions established by the vesting schedule are met, the employee receives the shares or a form of compensation with an equivalent value.

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Restricted Stock Units (RSUs): Pros and Cons to Employer

From the perspective of the employer, there are numerous benefits to issuing restricted stock units (RSUs) to employees.

• Performance Reward: For companies aiming to reach the next stage of growth or continue their upward trajectory, it is imperative that the contributions of individual employees are not left unacknowledged. Otherwise, an employee that had a critical role to the company’s functions could feel neglected and leave for a different role elsewhere, which would be a substantial loss to the employer.
• Non-Cash Expense: RSUs are a method to compensate employees while still conserving cash (i.e. no upfront cost is incurred). Hence, RSUs are often issued by venture-backed startups on the verge of going public via IPO or by high-growth publicly-traded companies that are still unprofitable due to significant spending needs.
• Limited Dilution: While one drawback to RSUs is the creation of additional shares (and thus, dilution in ownership), no shares are issued on the grant date and an employee’s RSUs vesting implies their performance must have contributed to the company’s long-term success. For most shareholders, the trade-off between competent, long-term employees and incurring a minimal amount in dilution is well worth it, especially considering how the valuation of a company is largely a byproduct of its employees collectively performing their roles well.
• Employee Retention: The inclusion of RSUs as part of an employee’s compensation package can help a company not only attract top talent when recruiting new hires, but also retain them for the long term. High employee attrition can be costly and time-consuming for a company, as well as ruin overall employee morale in the workplace. Therefore, RSUs can be a tool to increase the likelihood that top-performing employees are committed to remaining at the company for the long run.
• Incentive Alignment: As mentioned earlier, RSUs can align the incentives of employees and all equity shareholders. Since employees are granted conditional stakes in the company’s equity, the RSUs can function as a motivator to outperform and contribute to the company’s attainment of its long-term goals. There is no “ceiling” on the upside of RSUs, so employees can be further compelled to increase the value of their potential underlying shares.

Employee Compensation: Restricted Stock Units vs. Stock Options

Restricted stock units (RSUs) and stocks options are both forms of equity-based compensation provided by companies to their employees.

The underlying motive behind these issuances is essentially identical, but there are some notable differences between the two securities.

• Vesting Schedule: The vesting of RSUs is outlined in the agreement, which contain the specific terms that dictate the vesting requirements, the important dates, and the distribution process. On the other hand, employee stock options come with a fixed vesting schedule, which is more-so related to restricting the exercise date as a method to improve employee retention.
• Optionality: With stock options, the employee owns the right but not the obligation to purchase the shares at a predetermined price—i.e. the options’ “strike price”—for a set number of years. As a result, even if the option is exercisable, the employee can opt to take the risk of continuing to hold on to the option for the sake of realizing more profits, assuming there are no restrictions in place.
• Individual vs. Stock Price Performance: The vesting requirements of RSUs can vary substantially by company, but individual contributions like employment duration and achieving certain performance targets are frequently incorporated. In comparison to RSUs, employee stock options are more share-price-oriented, since the option value drops to zero and becomes worthless if the securities are out-of-the-money (i.e. share price < strike price). The option value is tied to external factors, such as investor sentiment in the public markets, macroeconomic conditions, etc.
• Payment Requirement: For employee options, the recipient must purchase the shares at the option’s strike price, and the excess of the market price over the strike price represents the profit earned. With restricted stock units (RSUs), an employee is seldom required to contribute any capital to receive the payout of shares from RSUs.

Taxation on Restricted Stock Units: RSUs Tax Liability

After the initial grant of RSUs to an employee, the shares are not in their possession until the vesting requirements are met. Thus, there are no tax consequences on the grant date, since no shares were technically distributed yet.

However, once the shares vest and all the necessary conditions are met, the distribution of the shares triggers a tax liability.

In the U.S., the general tax treatment of vested RSUs is as ordinary income. The taxable income is calculated based upon the fair market value (FMV) of the shares at vesting, i.e. the date of RSU stock issuance.

The market value of the vested RSUs is treated by the IRS as employee compensation and deemed to be taxable income, akin to a cash bonus, but paid in stock instead.

Restricted stock units (RSUs) are subject to federal and employment tax, as well as the applicable state and local tax. However, the taxation can vary by jurisdiction and the specific terms outlined within the RSUs agreement, so per usual, it is recommended to consult with a certified tax professional.