Restricted Stock Units Unpacked
Introduction
For many startup companies, compensating directors, officers, and employees can pose quite the challenge. While startup companies want to lure top talent, and incentivize workplace continuity and employee buy-in, they are often stressed for capital, and need to keep overhead costs low. One common approach to balancing these interests is for companies to offer restricted stock units (“RSUs,”) to their directors, officers, and employees as a form of compensation.
Restricted Stock Units- Overview
RSUs represent a right to receive shares in a company at the time they vest or at a later point, and are often used as a form of compensation for company employees, executives or directors. RSUs can come with restrictions on when they can be vested and how they can be transferred. Companies may elect to have time-based or performance-based vesting conditions for RSUs. Time-based vesting periods tie the vesting of RSUs to specific periods of time over which the individual must continue to provide services. For example, RSUs which vest after five years of employment with a company, is a time-based vesting period. In contrast, a performance-based vesting period requires certain company performance milestones to be met prior to vesting. For example, a company may grant RSUs which vest once a certain task has been completed by someone, or once the company reaches specific financial goals. A company can also create a system where RSUs are partially time-based and partially performance-based.
With respect to the time-based vesting, there are a number of ways that a company can fix the vesting amounts. Under a “cliff” schedule, all RSU’s vest at once, while under a “graded” schedule, RSUs begin to vest prior to the end of the agreed upon final vesting date or benchmark, and finish vesting at the end of the vesting period. For example, if an employer awards an employee 100 RSUs to vest at the end of five years of employment with the company, under a “cliff” schedule, all 100 shares will vest at the conclusion of the five years of employment. Under a “graded” schedule, the parties can reach an agreement where 25 RSUs will vest after the third year of employment, another 25 RSUs will vest after the fourth year of employment, and the final 50 RSUs will vest after the fifth year of employment. Companies can also combine these vesting schedules such that a portion is subject to cliff vesting and the remaining portion vests ratably over a period.
If the recipient fails to meet the vesting requirements for their RSUs, the RSUs are forfeited, and the corresponding shares are not issued. RSUs do not carry with them voting rights because RSUs represent the right to shares in a company if a particular event happens in the future. However, once vested, shares in a company underlying the RSUs are transferred to the individual, and carry with them all the rights that shareholders in the company have applicable to those shares (which may include voting rights).
There are costs and benefits to a company issuing RSUs. The main reason why companies issue RSUs as a form of compensation is to incentivize employment continuity and employee ownership in the success of the company. However, as with all issuances of stock, the granting of RSUs can dilute the shares held by others when the RSUs vest. This could decrease the value of the shares held by others.
Restricted Stock Units vs. Employee Stock Options
RSUs and employee stock options (“ESOs”) are both forms of equity that a company can grant to someone. However, there are distinct differences between the two of them. RSUs represent “full value” shares in a company that are vested at a later point. In contrast, ESOs represent the right for someone to buy shares of a company stock in the future, after the vesting period and prior to the expiration date, at a predetermined price that is fixed on the date of grant, allowing them to participate in only “upside” on the value of the stock. If the conditions of vesting are met, grantees with RSUs automatically receive shares of the company at the conclusion of the vesting period or at some other time designated in the grant agreement. In contrast, grantees of ESOs will have the option to purchase shares at a predetermined price, but will only get those shares if the grantee pays the predetermined price when the options can be exercised. If the shares are worth more than the predetermined price on the exercise date, the grantee will likely exercise those ESOs. If shares of the stock are worth less than the predetermined price when the ESOs can be exercised, the grantee will probably not exercise their right to purchase the shares. Until the right to purchase the shares are exercised by the grantee, the grantee is not a shareholder of the company and does not have any shareholder rights. Further, the grantee also takes on an investment risk should the shares have a lower value after exercise, whereas an RSU holder never has to come out of pocket and take that same investment risk.
Tax Implications
There are important tax implications that arise when being granted RSUs. Receiving RSUs is not in itself a taxable event because the recipient is not receiving any property. Rather, the transfer of the property happens in the future after the vesting conditions have been satisfied. Shares of a company given in exchange for services are governed by (§) 83 of the Internal Revenue Code of 1986. Under (§) 83(b), the recipient will be taxed on the value of the RSUs at the time the underlying shares are issued. If the shares have significant value, this can lead to a large ordinary income tax liability. Since the IRS does not accept shares in settlement of a tax liability, the recipient has to provide the cash to pay those tax liabilities.