Restricted Stock Units

What Are Restricted Stock Units?

Restricted Stock Units or RSU can be defined as stock-based compensation that is issued as company’s stock to an employee, however, this type of grant is limited and is subject to a vesting schedule. The company establishes vesting requirements based on the performance of an individual and the length of the employment.

Amazon utilizes Restricted Stock Units as a primary source for equity compensationEquity CompensationEquity Compensation refers to non-monetary pay that allows an employee to receive a part of ownership in the firm and therefore agrees to work at a lower salary (or zero salaries). With this, the company benefits by retaining talent and helps in controlling costs, whereas, employees benefit by way of capital appreciation of shares and large payouts in case the company does well in the future.read more as it aligns the long-term interests of both the shareholders as well as the employees.

Restricted Stock Units - Amazon

source: Amazon 10K K Filings

Once the restricted stock unit is assigned to an employee at a fair market value, they are considered as an income to the employee. Since it is an income, the company withholds a percentage of the shares to pay income tax. Nevertheless, the employee can receive the remaining shares and has the authority to sell them at any time at his convenience.

Apple - Restricted Stock Unit Grant

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Source: Restricted Stock Units (wallstreetmojo.com)

Restricted Stock Units Example

Suppose a person gets a job proposal from a company. The company believes that his skill set will turn out to be a good asset for the company. Therefore, the company decides to offer him 600 restricted stock units as part of the company compensation, apart from giving him a substantial salary and other benefits. The shares of the company trade at a market price of $50 per share that makes 600 RSU worth more than $30,000. The determination of the market price is usually done based on either the prior day’s close price of the stock or the average of high and low of the day.

However, if the person is supposed to get $30,000 as an incentive, he has to serve the firm for five years, due to its vesting schedules. The person will be eligible for 20% of the total RSUs at the end of year one of its employees. Another 20% of the total RSUs in the second year. So on until he gets all the 600 RSUs by the end of year five. Whatever be the price of the shares at the end of year five, the person will receive approximately $30,000 at the end of the fifth year.

Thus, RSUs work as a motivational factor in the organization. It not only allows the employees to stay with the organization but enable them to perform well, which in turn, results in the increased performance of the shares eventually. For instance, the person stays with the organization for the next five years to get all the 600 RSUs and by that time the price of share increases to $70 per share, he will end up receiving nearly $42,000. However, it is a taxable income, so the company will hold a few of its shares for the income tax and the capital gain tax.

In contrast, if the person would have left the job during the vesting period, he wouldn’t be eligible for this reward. For example, let us assume that the person leaves the job after one year of his employment, then, he will be available for only 150 RSUs, and he would forfeit the remaining 450 shares of the company.

RSU – Difference between the grant date and vesting date

One should not get confused with the grant date, and vesting date as both dates are different. On the grant date, the company provides your restricted stock units. However, you are not allowed to sell or transfer the RSUs for a particular time. Once this particular time is up, the company gives permission to sell or transfer the RSUs, which is known as vesting date. There are several enterprises that ask the employees not to sell or transfer vested sharesVested SharesShares vesting refers to the grant of shares over a pre-decided tenure as the compensation package or contribution towards the pension scheme to the employees or to the founders of the company to reward them for their work performance and to retain them for longer years in the company.read more for a period.

Amazon’s Restricted Stock Units schedule is provided below.

Amazon - RSU Restricted Stock Units Vesting

source: Amazon 10K Filings

Amazon has granted a total of 19.8 million RSUs, out of which 7 million RSUs vests in 2017 and 7.2 million RSUs vest in 2018.

RSUs – A Full Value Grant

Restricted stock units are considered a total amount stock grant for the reason that the grant is worth the full value of the shares at the time of vesting. Thus, unlike the stock options that often considered underwater, RSUs will not result in any loss, meaning the outcome will always lead to some income even though the market price drops.

RSE Example

A company grants 15000 RSUs to an employee. On the vesting date, when the shares are given to you, the stock price of the company is $20 per share. It results in a grant value of $300,000 (15000*20). However, if the stock price were $15 a share at the vesting date, the grant value would still be worth nearly $225,000 (15000*15). It is because the restricted stock units do not consider the grand date. Instead, they take into consideration the vesting date.

SharesThe stock price at VestingValue of shares at vesting or delivery
15000$20300,000 (15000*20)
15000$15225,000 (15000*15)

Below is Amazon’s Restricted Stock Unit Activity in the years 2014, 2015, and 2016.

We note that the total RSUs granted in 2016 was 9.3 million, RSUs vested was 6.1 million, and RSUs forfeited was 2.3 million.

Amazon - RSU Restricted Stock Units Grant Vesting 1

Taxation of Restricted Stock Units

When the shares of restricted stock units are delivered to the employees at the vesting date, they are taxed. Thus, the taxable income of the employees could be the market value of the shares at the time of vesting. Now, the employees have a compensation income, which is subjected to federal and employment tax as well as any state and local tax. For the U.S. employees, the withholding taxThe Withholding TaxWithholding tax is a part of the salary an employer withholds from an employee's compensation and pays to the legal authorities. It is treated as collateral imposed against the taxes an employee is liable to pay during a particular year.read more appears on the Form W-2 along with their income.

Suppose an employee is delivered 1000 shares at the vesting date with a fair market value of $20 per share. Therefore, he will recognize a taxable income of $20,000. Since this income is taxable, his company may offer various options to pay the tax due on $20,000 with the following choices.

#1 – Withhold-to-Cover

As per this choice, the company is expected to withhold a few of the vested shares to the employee in order to pay the applicable taxes. Now, let us consider that the withholding tax rate is around 40%, then, as per the above example, the taxes due to the employee would be nearly $8000 ($20,000*40% = $8000). Thus, the number of shares that the company is likely to withhold could be 400 ($8000/$20 = 400). So, in this case, the company will withhold 400 shares and release the remaining 600 shares.

Below is an extract from Apple’s 10K Filings. We note that most of RSUs vested were net-share settled, i.e., Shares were withheld to cover the tax obligations and were remitted in cash to the appropriate taxing authorities.

Apple Restricted Stock unit Taxation

source: Apple 10K Filings

#2 – Cash

The employees may have the option to pay the taxes directly to their companies through payrollPayrollPayroll refers to the overall compensation payable by any organization to its employees on a certain date for a specific period of services they have provided in the entity. This total net pay comprises salary, wages, bonus, commission, deduction, perquisites, and other benefits.read more or check, and the employees can have their account credited with the full number of vested shares.

#3 – Sell-to-Cover

Sell-to-cover is an additional option for the employees to pay their taxes. Considering the above example, the employee can ask any stock market firms such as Morgan Stanley to sell 400 shares of the total vested shares of 1000 shares to cover his taxes. However, they may charge him applicable commissions and fees for the service. The proceeds from the sales will be debited to your account and will be sent to the employee’s company for reporting and remitting to the appropriate regulatory agencies.

Benefits of Restricted Stock Units (RSU)

  1. Possible Lower Taxes – Restricted stock units don’t include section 83(b) provision. Therefore, the possibility of the overpayment is minimum in the case of RSUs.
  2. Deferral of Share Issuance – Companies or organizations can issue restricted stock units without diluting the share base. This creates a substantial advantage over the other form of equity compensations such as employee stock purchase plansEmployee Stock Purchase PlansEmployee Stock Purchase Plan is an option granted by the employer to the employees, wherein the employer (i.e. the company) allots a specific quantity of shares/stocks to each of the employees at a significantly discounted price as compared to the market price. Employees avail this option through periodical deduction from the date of grant of option till the date of exercise of the price required to be paid.read more, statutory or non-statutory stock option schemes.
  3. Economical – Companies or organizations incur minimum administrative expenses because there are no actual shares to hold, record, and track.
  4. Tax Deferrals – The companies or firms can defer taxation beyond the vesting date by delaying the issuance of shares to the employees.
  5. Foreign Tax-Friendly – Restricted stock units for the U.S. employees working outside the United States have similar taxation as compared to those working in the home country. They are taxed on the value of the tax at the time of delivery, not grant and liable to the capital gain tax on the sale of stocks.

Drawbacks of RSUs

  1. No Voting Rights – Restricted stocks units do not allow the employees to have voting rights at the time of the grant. Instead, they are given the right to vote when the actual shares are issued to employees at vesting.
  2. No Dividends – Restricted stocks Units have no option to pay the tax due to the fact that no actual shares are given to the employees. However, the employer can pay a cash dividendCash DividendCash dividend is that portion of profit which is declared by the board of directors to be paid as dividends to the shareholders of the company in return to their investments done in the company. Such a dividend payment liability is then discharged by paying cash or through bank transfer.read more equivalents if the employees select the dividend option.
  3. No Section 83(b) Election – Restricted stock units exclude section 83(b) election because the units given to the employees are not considered tangible property according to the Internal Revenue Code. Therefore, such kind of election can only be possible with the real property.

Restricted Stock Units vs. Stock Options – Key Differences

You can have a better understanding of restricted stock units when you compare it with the traditional stock options. In the United States, there are basically two types of stock options, namely- ISOs and NSOs. However, I will use incentive stock options (ISO) to highlight key differences in restricted stock units and ISOs.

  1. Grant Date – the selection of grant dates could be anytime after the employment of an individual, followed by an issuance of RSUs or options. There is no difference between these two on the grant date.
  2. Exercise Price – Restricted stock units do not have any strike price. RSUs are issued to the employees based on the market price of the company’s share at the close of the previous day. But, in the case of the stock option, the exercise priceExercise PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more is determined by the future market value of the firm’s share.
  3. Vesting – RSUs and options both can be vested based on the performance of the employees and the period of employment in the company.
  4. Shareholders’ right – Restricted stock units do not give any right to the employees, such as voting and dividend. However, the recipient of the RSUs will be eligible for these rights if the company gives the employee the stocks and not the cash. Meanwhile, under the incentive stock optionsIncentive Stock OptionsIncentive Stock Options, also known as Qualified Stock Options, are employee compensation type that gives them the right to buy the Company’s stock at a price lower than the current market price. Furthermore, businesses use them to retain their top-tier employees for the long run. read more, the recipients become a full shareholder of the company once the options have been exercised.
  5. 409A Treatment – RSUs are not entitled to the 409A valuation, whereas ISOs naturally requires a 409A valuation.
  6. Settlement – RSUs are settled at the end of the terms and conditions of the agreement. Most often, the company delays the settlement for availing a better tax treatment because the deferral beyond a number of months could lead to adverse 409A consequences. In contrast, there is no such settlement for incentive stock options. Once an employee completes the vesting period, the stock optionsStock OptionsStock options are derivative instruments that give the holder the right to buy or sell any stock at a predetermined price regardless of the prevailing market prices. It typically consists of four components: the strike price, the expiry date, the lot size, and the share premium.read more become common stocks that the employee can exercise at his will.
  7. Type of payment upon settlement – the payment upon the settlement is given in cash or shares under RSUs. Meanwhile, ISOs provide shares to the employees as payment at the settlement.

Conclusion

A restricted stock unit (RSU) is one of the packages of equity compensation offered by a company to its employees in terms of company shares. However, the shares of the company are given to the employees on the future date as per the vesting plan of the company. The employee receives the stock compensation after they complete the vesting requirement, such as required performance milestones and serving the company for a particular length of time.

Restricted stock units are considered a better equity compensation as compared to the stock options as RSUs have provided downside protection. It only states that the employer is giving more money to its employees. In straightforward words, restricted stock units enable the employees to get richer with the growth of the company. RSUs are gaining popularity quickly due to its benefits over the other equity compensations. According to radford.aon.com, only 3% of technology companies had RSUs-centric equity plans eleven years ago in the U.S. However, this number has grown to more than 50% in the technology as more and more companies started practicing restricted stock units.

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