source: Business Insider
Restricted Stock Units or RSUs is one of the popular way of equity compensation used by Employers for stock-based compensation. RSUs is valued in stocks at the time of grant, however, it is not passed to the employees until they satisfy the vesting requirement.
The above extract is Tim Cook (Apple) memo on Stock Ownership Program for employees. Apple initiated its Restricted stock Units plan to retain and motivate their employees.
In this article, we look at Restricted Stock Units in detail.
- What are Restricted Stock Units or RSUs?
- Why is it Restricted?
- Restricted Stock Units Example
- RSU – Difference between grant date and vesting date
- RSUs – A Full Value Grant
- Taxation of Restricted Stock Units
- Benefits of Restricted Stock Units (RSU)
- Drawbacks of RSUs
- Restricted Stock Units vs Stock Options – Key Differences
What are Restricted Stock Units or RSUs?
A restricted stock unit (RSU) is one of the packages of equity compensation offered by a company to its employee in terms of company shares. However, the shares of the company are given to the employees at 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 milestone and serving the company for a particular length of time.
Amazon utilizes Restricted Stock Units as a primary source for equity compensation as it aligns the long-term interests of bot the shareholder’s as well as the employees.
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 to the employee, the company withhold a percentage of the shares in order to pay income tax. Nevertheless, the employee can receive the remaining shares and has an authority to sell them at any time at his convenient.
Why is it restricted?
It is because the grant is limited and is subject to a vesting schedule. The company establishes vesting requirements based on the performance of an individual and a length of the employment. Apart from these basic requirements, the company sets the limits on the transfer or sales of the units. If an individual does not meet these requirements set forth by the corporation before the end of vesting period, the units of a person are forfeited to the enterprise.
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 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 employment and another 20% of the total RSUs in the second year and so on until he gets all the 600 RSUs at 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 increase performance of the shares eventually. For instance, the person stays with the organization for the next five year 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 the 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 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. In fact, there are a number of enterprises they ask the employees not to sell or transfer the vested shares for a period.
Amazon’s Restricted Stock Units schedule is provided below.
source: Amazon 10K Filings
Amazon has granted a total of 19.8 million Restricted Stock Units, out of which 7 million RSUs vest 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.
A company grants 15000 restricted stock units 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 the 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.
|Shares||Stock price at Vesting||Value of shares at vesting or delivery|
Below is Amazon’s Restricted Stock Unit Activity in the year of 2014, 2015 and 2016.
We note that the total RSUs granted in 2016 were 9.3 million, RSUs vested were 6.1 million and RSUs forfeited were 2.3 million.
Taxation of Restricted Stock Units
When the shares or restricted stock units are delivered to the employees at 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 tax appears on the Form W-2 along with their income.
Example of RSU taxation
Suppose, an employee is delivered 1000 shares at the vesting date with the 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 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.
source: Apple 10K Filings
#2 – Cash
The employees may have the option to pay the taxes directly to their companies through payroll 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 to the employees to pay his 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)
- Possible Lower Taxes – Restricted stock units don’t include section 83(b) provision, therefore, the possibility for the overpayment is minimum in the case of RSUs.
- 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 plans, statutory or non-statutory stock option schemes.
- Economical – Companies or organizations incur minimum administrative expenses because there are no actual shares to hold, record and track.
- Tax Deferrals – The companies or firms can defer taxation beyond the vesting date by delaying the issuance of shares to the employees.
- 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
- No Voting Rights – Restricted stocks units do not allow the employees to have voting rights at the time of grant. Instead, they are given the right to vote when the actual shares are issued to employees at vesting.
- 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 dividend equivalents if the employees select the dividend option.
- No Section 83(b) Election – Restricted stock units exclude the 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.
- Grant Date – the selection of grant date 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.
- Exercise Price – Restricted stock units do not have any strike price. RSUs are issued to the employees based on the market price of company’s share at the close of the previous day. But, in the case of stock option the exercise price is determined by the future market value of the firm’s share.
- Vesting – RSUs and options both can be vested based on the performance of the employees and period of employment in the company.
- 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 options the recipients become a full shareholder of the company once the options have been exercised.
- 409A Treatment – RSUs are not entitled to the 409A valuation, whereas, ISOs naturally requires a 409A valuation.
- 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. While there is no such settlement for incentive stock options. Once an employee completes the vesting period the stock options become common stocks that the employee can exercise at his will.
- Type of payment upon settlement – the payment upon the settlement is given in cash or shares under RSUs. Meanwhile, ISOs provide shares the employees as a payment at the settlement.
Restricted stock units are considered a better equity compensation as compared to the stock options as RSUs have provided a downside protection. It only states that the employer is giving more money to its employees. In the 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.