Restricted Stock Units (RSUs) 101
Restricted Stock Units (RSUs) are a powerful tool that can help you build wealth and secure your financial future. But before you dive in, it's essential to know the ins and outs of these mighty vehicles.
Let’s go over everything you need to know about RSUs—from how they're granted to the potential downsides.
What are RSUs?
Restricted Stock Units (RSUs) are a form of equity compensation offered by many companies to their employees as part of their equity compensation packages.
An RSU is a promise made by the company to give the employee a certain number of shares of the company's stock at a future date, subject to certain conditions, such as continued employment with the company.
Unlike stock options, which give the employee the right to purchase shares of stock at a set price, RSUs are granted with no upfront cost to the employee. The value of the RSU is tied to the stock price of the company; therefore, the employee benefits from any increase in the stock price.
When the RSUs vest, the employee will receive the shares of stock and may choose to sell them, hold onto them, or take other actions.
How are RSUs granted?
Restricted stock units are typically granted by a company's board of directors or compensation committee as part of the company's equity plan. The number of RSUs granted to an employee can vary depending on job level, performance, and length of service with the company.
The grant of RSUs is typically documented in an RSU award agreement, which outlines the terms and conditions of the grant. This agreement is where an employee would find critical items such as the vesting schedule and any restrictions on the transfer or sale of the shares.
The award agreement may also include information about the company's equity plan and the provisions that govern the grant of RSUs.
In some cases, the employee may be required to sign a separate agreement that includes specific terms related to the RSU grant, such as restrictions on the transfer or sale of the shares and the consequences of termination of employment before the RSUs vest.
When do RSUs vest?
Restricted stock units typically vest over a set period, such as 1, 2, or 4 years. The vesting schedule outlines when the employee will become entitled to receive the shares of the stock underlying the RSUs.
Vesting schedules can vary, and companies may use different schedules for different types of employees or grants.
VESTING SCHEDULE EXAMPLE
Let’s say a company grants an RSUs with a vesting schedule that requires the employee to remain employed by the company for four years, with 25% of the RSUs vesting each year.
In this case, the employee would receive 25% of the RSUs after one year of service, 50% after two years, 75% after three years, and 100% after four years.
It’s important to note that not all restricted stock units have a linear vesting schedule over time. Some companies, such as Amazon, have elected to utilize backloaded vesting schedules where the employee may only vest twenty percent over the first two years (5% in year 1 and 15% in year 2), with heavier vesting occurring in years three and four.
Of course, this is strategic planning on the company's part to help ensure the employee stays with the company instead of leap-frogging every two years as tech employees have been known to do—especially during the 2010's tech boom.
It's essential to understand the specific terms of the vesting schedule for each RSU grant, as the vesting schedule can significantly impact the grant's value and the tax implications for the employee. If the employee leaves the company before the RSUs vest, they may forfeit any unvested RSUs, so it's essential to understand the consequences of termination of employment before the RSUs vest.x
How are RSUs taxed?
The taxation of RSUs depends on several factors including:
the country where the employee is located
the country where the company is headquartered
the specific tax laws and regulations that apply to the employee's situation
In the United States, for example, RSUs are taxed as income at the time they vest, and the employee must pay federal income taxes and state income taxes (where applicable) on the value of the shares received. The employee may also be subject to payroll taxes, such as Social Security and Medicare taxes, on the value of the RSU at the time of vesting.
The value of the RSU is typically based on the fair market value of the stock on the date the RSUs vest. If the employee chooses to sell the shares, they may also be subject to capital gains taxes, depending on how long they held the shares and the difference between the sale price and the original value of the RSU.
The tax treatment of RSUs can frankly be complex, and the specific tax implications of an RSU grant may vary depending on the individual circumstances of the employee. Employees are encouraged to consult with a financial advisor or tax professional to understand the tax implications of their RSU grant and to plan for the tax consequences of receiving the shares.
What happens when RSUs vest?
When RSUs vest, the employee becomes entitled to receive the shares of the stock underlying the RSUs. Once the RSUs vest, the company will typically arrange to transfer the stock shares to the employee's brokerage account. The employee will then be free to sell the shares, hold onto them, or take other action with them, depending on their financial goals and the terms of the RSU award agreement.
In some cases, the company may require the employee to sell a portion of the shares to cover the taxes owed on the RSU grant. This process is generally known as "sell to cover," as you are selling to cover taxes. You can think of this process as another form of tax withholding, similar to your salary pay: the remaining shares can then be sold or held as desired. Should the employee decide to hold onto the shares, any additional share price gain beyond the vesting price will be subject to capital gains tax.
If you keep those shares for more than 365 days, that capital gains tax will be considered long-term capital gains, just like if you had purchased the company stock in your brokerage account. Another payout option that some companies offer is an automatic sale plan where all stock shares are sold at the fair market value on the vesting date. Again, tax withholding will be applied as mentioned above, and the proceeds are then provided to you as cash payment instead of a stock transfer.
What happens if the employee leaves the company before the RSUs vest?
Employees who leave the company before the RSUs vest may forfeit any unvested RSUs. The specific terms of the RSU award agreement will dictate what happens to unvested RSUs in the event of employment termination. The consequences of leaving the company before the RSUs vest can vary depending on the circumstances of the termination.
For example, the RSU award agreement might specify that unvested RSUs will be forfeited if the employee leaves the company voluntarily or is terminated for cause. On the other hand, the agreement might allow the RSUs to vest pro rata based on the length of service with the company or to vest in full in case of a termination due to disability or death.
It's crucial for employees to review the terms of their RSU award agreement carefully and to understand the consequences of termination of employment before the RSUs vest.
How do RSUs affect ownership in the company?
Receiving RSUs gives the employee an ownership stake in the company, as they will own shares of the company's stock. This equity compensation can be attractive for employees who want to align their interests with those of the company and have a vested interest in its success.
Restricted stock units can affect ownership in a company in several ways. When an employee is granted RSUs, they become entitled to receive a specified number of shares of the company's stock at a future date, subject to the terms of the RSU award agreement.
Upon vesting of the RSUs, the employee will own the underlying shares of stock and will be able to sell them, hold onto them, or take other actions with the shares, depending on the terms of the RSU award agreement and their financial goals.
Ownership of the company's stock through RSUs can provide employees with a direct financial stake in the company's success, as the value of the shares will typically increase if the company performs well. This incentive can help align the interests of employees with those of the company, as employees will benefit if the company's stock price rises.
RSUs can also affect ownership in a company by increasing the overall number of shares outstanding, which can dilute the ownership percentage of existing shareholders. This dilution process can be a concern for some existing shareholders, as dilution can reduce the value of their existing shares and decrease their voting power in the company.
RSUs vs. Stock Options
Stock options are the right to purchase a specified number of shares of the company's stock at a set price, known as the exercise price. The employee has the option to buy the shares at the exercise price at any time during the option's term, which is typically ten years. If the value of the stock increases, the employee can buy the shares at the lower exercise price and then sell them for a profit. Tax implications: Options are taxed at the time of exercise when the employee buys the shares, and the employee may be subject to both ordinary income tax and capital gains tax, depending on how long they hold the shares.
RSUs, on the other hand, do not give the employee the right to purchase the company's stock at a set price. Instead, RSUs are future promises to deliver a specified number of shares of stock to the employee at a future date (typically when the RSUs vest). The employee does not have to pay anything to receive the shares, and they will typically receive the total value of the shares at vesting, subject to any deductions for taxes. Tax implications: RSUs are taxed as income when they vest when the employee receives the shares, and the employee is subject to ordinary income taxes and payroll taxes, such as Social Security and Medicare taxes, on the value of the restricted stock unit at the time of vesting.
Stock options provide employees with the opportunity to benefit from the company's growth by allowing them to purchase the company's stock at a set price, while RSUs offer employees a direct benefit in the form of shares of stock that they will receive in the future. The choice between RSUs and stock options will depend on the specific needs and goals of the employee, as well as the terms of the award agreement and the tax implications of each type of compensation.
What are some of the potential downsides of RSUs?
Vesting risk: If an employee leaves the company before the RSUs vest, they may forfeit any unvested RSUs, resulting in a loss of potential compensation.
Market risk: The value of the underlying shares of stock may fluctuate, and if the stock price decreases, the value of the RSUs will also decrease. This price drop can result in a loss of potential compensation for employees.
Dilution: The grant of RSUs increases the overall number of shares outstanding, which can dilute the ownership percentage of existing shareholders. This dilution can reduce the value of existing shares and decrease the voting power of existing shareholders.
Complexity: RSUs can be complex and challenging to understand, particularly concerning the tax implications of the compensation. Employees should consult with a financial advisor or tax professional to understand the full impact of their RSU award on their finances.
Timing: The timing of the vesting and settlement of RSUs can be uncertain, as it may be subject to conditions such as the achievement of performance goals or the completion of a specified period of service.
DID YOU KNOW?
The company stock you own is likely owned by dozens, if not hundreds, of ETFs and mutual funds. If you're looking to diversify your company stock but want to stay invested in a similar basket of aggressive growth stocks, consider researching which funds own your company stock. A common example is Invesco's QQQ (ticker: QQQ) which holds a basket of the top 100 NASDAQ companies.
I want to learn more about RSUs; where should I start?
Company websites or employee handbooks: Many companies provide information about their equity-based compensation programs, including RSUs, on their websites or in employee handbooks. These resources can be an excellent place to start for employees who want to learn more about their RSU award.
Financial advisors or tax professionals: If you have specific questions about the financial or tax implications of your RSU award, you should consult with a financial advisor or tax professional. They can help you understand the terms of your RSU award agreement and can guide the impact of your RSU award on your finances. Our team at DiversiFi is well-versed in stock-based compensation; we’re here to help!
Online resources: A variety of online resources are available to help employees learn more about RSUs. Websites such as Investopedia, The Balance, and others provide educational articles and guides on equity-based compensation, including RSUs.
Professional organizations: Organizations such as the National Association of Stock Plan Professionals (NASPP) provide educational resources and support for individuals participating in equity-based compensation programs. They can be a good source of information for employees who want to learn more about RSUs.
Books: Although they may not be the most relaxing read, there are also books available on equity-based compensation, including RSUs. These books can provide a comprehensive overview of the topic and can be helpful for employees who want to learn more about RSUs in-depth.
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