Equity-based compensation such as restricted stock units (RSU) is a popular way for companies to attract job seekers and to incentivize employees. These company shares are issued to employees upon meeting predetermined performance goals and/or remaining with the company for a stipulated period, according to a vesting plan.
However, this compensation is a little more complex than a cash bonus and is different from the shares you buy in the open market. It’s important to fully understand what restricted stock units are so you can make an informed decision on your compensation package.
The Short Version
- An RSU is a company share that an employee receives after a predetermined period of time.
- After the vesting period, these RSUs are the same as company stocks and will be taxed accordingly.
- Stocks give you more leverage but are riskier since RSUs retain their value no matter what the market does.
Why Do Companies Use Restricted Stock Units?
Companies use restricted stock units to retain talented employees and attract new ones. RSUs provide employees with the opportunity to reap significant profits if the company performs well over the vesting period.
Since the value of each RSU is attached to the performance of the company’s stock, employees have financial interest in a company’s long-term success. This, in theory, inspires a more robust commitment from the employee and aligns incentives for the employee and the company.
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How Do Restricted Stock Units Work?
RSUs typically require an employee to complete a predetermined tenure. Once completed, the employee’s now vested RSUs, or vested shares, become actual stock which can be sold for the value of the company stock.
RSU vesting schedules are generally structured in one of two ways:
- Graded — A portion of your RSUs vest periodically until the tenure requirement is met, assuming your performance meets predetermined standards.
- Cliff — 100% of your RSUs vest upon meeting your tenure requirement, or achieving individual or companywide performance milestones.
Vesting is usually terminated if you are fired. Sometimes exceptions are made for situations such as death, disability, or retirement. Shares are almost always delivered at vesting and are typically taxed as income.
Unlike common stock, RSUs don’t come with voting rights until they are converted to common shares.
An Example of a Graded Vesting Schedule vs. a Cliff Vesting Schedule
RSU vesting schedules are structured in two ways as discussed above—graded and cliff. Let’s look at an example of each.
Graded Vesting Schedule: Your new employer awards you a stock compensation of 5,000 RSUs. The company’s publicly traded stock is currently valued at $10 per share, which means that 5,000 RSUs are currently worth $50,000.
Your RSUs are on a two-year vesting schedule and you will receive 2,500 actual shares annually until you collect all 5,000 shares at the close of the vesting period.
A year passes. The company’s stock is now worth $13 dollars a share. That means the value of those 2,500 RSUs has increased from $25,000 to $32,500. The second year passes and the stock is now worth $15, so your remaining 2,500 RSUs will be worth $37,500 when vested. The total value you receive for the appreciated shares will be $70,000 for 5,000 RSUs, instead of the $50,000 value you started out with.
Cliff Vesting Schedule: In an alternate scenario, you receive the same deal as above, with one caveat — you receive all 5,000 shares after the two-year vesting schedule terminates.
After one year, the company’s stock rises to $13 dollars a share. Unfortunately, in the second year (when you receive your 5,000 shares) the company’s stock drops to $7. In this situation you can still choose to sell or hold. However, you do not reap any of the profits during the first year when the stock was at a higher price.
What’s the Difference Between Stock Options and Restricted Stock Units?
When an employer awards you with stock options, they are giving you the right, but not the obligation, to buy a specified number of shares of company stock at a predetermined stock price within a set time frame.
If the stock price appreciates beyond the strike price, the option can typically be sold for a profit or exercised. However, if the stock price falls below the strike price the options could be worthless.
RSUs do not have an expiration date, meaning you have the option to hold them if you choose to when vests are granted.
Basically, stock options have leverage and can potentially expire worthless while RSUs will retain value as long as the company’s shares have value.
Choosing between RSUs vs. Stock Options
The main consideration when choosing between RSUs and stock options is whether you want built-in leverage. If the company performs poorly and its stock price plummets, your stock option could expire worthless. But if the company performs well and the stock price surges, your stock options will typically make more than RSUs.
Are Restricted Stock Units Risky?
It’s safe to say that restricted stock units are typically less risky than stock options. RSU shares don’t require purchase–they simply become yours upon vesting. Furthermore, with RSUs you can potentially cover your tax liability by surrendering shares. However, there is still risk involved with RSUs:
- Stock price may decrease. RSUs, just like stock traded on the public market, can decrease in share price depending on the company’s performance.
- Your company isn’t public. A public company’s stock trades on a stock exchange, so there is typically enough liquidity to sell your vested shares. RSUs from private companies do not have this advantage. Although sometimes you can still sell your shares in a private market, It’s more difficult to find a buyer. Without a public marketplace for RSUs granted by a private company, you may have to wait until for a liquidity event like an initial public offering.
- You don’t fulfill the entire vesting period. The vesting period could pose an issue should you decide to switch companies before your stipulated tenure is met, in which case you may lose your unvested shares.
Are Restricted Stock Units Taxable?
Yes, restricted stock units are taxable. Income tax will typically be applied to the market value of the stock shares once they vest.
Tax Considerations for RSUs
More often than not, companies offer the choice to cover the tax burden by “tendering” shares under a net-settlement process. This process typically involves surrendering the stock from vested RSUs back to the company, which enables the company to pay for your taxes owed on the RSUs.
You should also consider short-term and long-term capital gains tax. If you hold your vested shares for more than one year, any profits you make will be subject to long-term capital gains tax.
An Example of How Restricted Stock Units Are Taxed
Let’s go over an example of taxes with RSUs. You receive 5,000 RSUs from a publicly traded company with a five-year vesting schedule. When you receive these RSUs the company stock value is $10 per share. The RSU vesting schedule is graded. The vest rate is 20% (1,000 shares) annually. Here’s how this might play out over the entire five-year vesting cycle:
Year one — $12 stock price at vesting, or $12,000 of ordinary income.
Year two — $14 stock price at vesting, or $14,000 of ordinary income.
Year three — $15 stock price at vesting, or $15,000 of ordinary income.
Year four — $17 stock price at vesting, or $17,000 of ordinary income.
Year five — $20 stock price at vesting, or $20,000 of ordinary income.
You are taxed when shares are acquired on the vesting date at each grade as compensation income. For example, the $12,000 market value of the vested shares for year one are subject to ordinary income tax, $14,000 for year two, and so on.
The stock has performed well over the past five years, so you decide to hold on to all of it. Three years later, you are in the market for a house and you need a down payment. You decide to sell all the shares at once at their current market value of $30 per share.
You will pay capital gains tax on your $72,000 profit ($150,000 minus $78,000). Since you waited more than one year to sell your shares, they will be taxed as long-term capital gains.
Pros and Cons of Restricted Stock Units
It’s important to consider how RSUs could impact your financial position compared to other forms of compensation and investments. Here are the major pros and cons of restricted stock units:
The Bottom Line
For many employees, RSUs are an attractive form of equity compensation. But if you want to determine how they will impact your financial situation, consider the terms for vesting, the future of the company awarding the RSUs, concentration risk, and liquidity. You have to assess your individual situation to see how RSUs will fit into your financial picture.
Disclaimer: The content presented is for informational purposes only and does not constitute financial, investment, tax, legal, or professional advice. If any securities were mentioned in the content, the author may hold positions in the mentioned securities. The content is provided ‘as is’ without any representations or warranties, express or implied.