Restricted-Stock-Units

Employers include several types of equity compensation in the employee’s compensation package. Each type has guidelines governing how equity is managed, granted, and taxed. To fully benefit from every type of equity, it’s essential to understand its nuances.

Nowadays, only a few companies pay their employees with stock options, and many have resorted to other methods, such as restricted stock units (RSUs), to compensate their employees. These new types of equity compensation provide several advantages for the company and the employees.

Over time, the RSUs can contribute significantly to an employee’s net worth. Hence, understanding the operation, taxation, and management of restricted stock unit compensation is critical. This article will explain everything one needs to know about RSUs.

 

What Is a Restricted Stock Unit?

 

The Restricted Stock Unit is a form of equity compensation that grants an employee a specific number of shares in the company, subject to a vesting schedule and other requirements. The vesting schedule determines when ownership rights become exercisable – usually after several service years.

Companies often give RSUs to new or valuable employees as a reward for employment or in response to attaining specified performance goals. In the case of a new hire, the restricted stock unit plan forms part of the employee’s preliminary compensation package.

 

How Do Restricted Stock Units Work?

 

With a restricted stock unit plan, the company gives the employee an economic stake in the company through a certain number of shares. However, the stock is not handed to the employee only after they meet a specific goal or after a few years of service, as decided in the employment contract. In other words, the restricted stock unit plan grants the employee a “vested interest” in the stock.

Employee benefits such as restricted stock unit plans are based on the company’s stock price. Once the RSUs have vested, they are distributed as either shares or cash, depending on the initial contract structure.

Restricted stock units have no tangible value until they vest; all the employee has is the promise of future stock issuance. The company does not give or make dividend payments to the holders.

 

Types of Restricted Stock Units (RSUs)

 

Employers may offer RSUs with different restrictions. Some are referred to as single-trigger RSUs because they are only subject to a vesting schedule. Others, known as double-trigger RSUs, may have additional requirements that the employee must meet along with vesting.

 

1. Single-Trigger RSUs: Time-Based Vesting

 

Single-trigger RSU grants only have a time-based vesting schedule, and the value of the RSUs is taxed as the time milestones are met, whether the company is public or still private.

A graded vesting schedule works with periodic grants and becomes fully vested over several years. Another option employers have is cliff vesting, in which all grants vest simultaneously. The grants have no value until the vesting date.

 

2. Double-Trigger RSUs: Performance-Based Goals

 

RSUs, in addition to a vesting timeline, may be subject to additional restrictions, usually linked to employee performance. This could entail the company achieving specific milestones, such as introducing a new product or service or going through a liquidity event, such as a merger, acquisition, or initial public offering (IPO), before going public by a direct listing, SPAC listing, or other means.

 

Valuation of Restricted Stock Units

 

RSUs can be valued using current or future valuation methods. Current valuations are based on the stock’s actual current value. However, future valuations are completely based on forecasts.

Current Valuation Method: Startups that have recently accepted venture capital funding benefit most from the current valuation method because the value is based on the price per share the lender pays. For instance, if a startup accepts the venture capital firm’s valuation at a per-share value of USD 50, then the current value of a single restricted stock unit will also be USD 50.

Future Valuation Method: This method involves estimating what the company thinks it will be worth at a certain future date. The company must project earnings and expenses and also foresee prospective future investments in the company to estimate the stock’s value accurately. Prospective employees should know that the value of the RSUs is purely based on the company’s estimation.

 

Tax Liability of Restricted Stock Units (RSUs)

 

Since employees do not legally own the shares until they meet the vesting prerequisites and other requirements, they will not be taxed till then. However,  when the employer transfers the shares to the employee, they become taxable. This occurs each time a portion of the shares vests. The market value of the shares at the time of vesting represents the taxable income. The vested shares are subject to federal and employment taxes, including medicare and social security taxes.

The value of the vested shares equals the number of shares multiplied by the shares’ fair market value. This value is taxable as income to the employee, so the company must withhold the necessary taxes.

Some companies offset the tax liability by reducing the shares received. For instance, if 300 shares vest and the value of each is USD 10, the employee will be required to pay tax on USD 3,000 of income. Assuming a 30% tax rate, the tax bill will be USD 900, or 90 shares. The employee can choose only to get 210 shares and pay taxes with 90 shares.

 

Selling Restricted Stock Units Shares

 

Whether an employee can sell the shares to generate cash depends on whether the employer is a private or public entity.

Public company: If the organization is publicly traded, its shares will often be exchanged on a stock exchange. This implies that the employee can sell the shares at any time if they are satisfied with the share price. Employees can sell shares after vesting if they need the funds to pay taxes. Some employees can decide to hold onto their shares out of loyalty to the firm or because they have confidence in its future growth prospects.

If selling shares generates a capital gain, there may also be tax consequences. An investor who holds shares for more than a year before selling them qualifies for a long-term capital gain, typically taxed at a lower rate than a short-term capital gain.

Private company: If the company is a private entity, the shares cannot be easily sold since there is no marketplace to sell the shares. Therefore, employees may be required to pay taxes out of their pocket. Some companies offer double-trigger restricted stock unit plans with a liquidity event clause to allow employees to sell the shares if a liquidity event occurs. Employees can use the sale to pay the tax liability. However, some liquidity events, such as SPAC listing or IPO, have lock-up periods, which prevent the employee from selling the shares immediately.

 

Things to Consider Before Selling RSUs

 

Once the RSUs have vested, it’s time to implement the restricted stock unit plan. The restricted stock unit approach the employee selects should make sense for the financial requirements and long-term goals. A few things to consider before selling the RSUs:

Why do you want to sell? –  Do you want to diversify your concentrated stock position? Do you intend to reinvest in any other assets?

What is the company’s outlook? – The plan will be strongly influenced by the company’s expected future success and stock price.

Does your employer compel you to own shares in the company? – Some firms mandate that senior executives keep a specific percentage of the company’s shares in their portfolios.

Suppose the employee decides to sell restricted stock unit shares. In that case, there are many alternative investment options that the employee can invest in using the money received from the sale of the shares. For example, the employee may diversify their portfolio by selling half of the vested shares and buying a hard asset, such as a rental income-generating asset.

 

Different Selling Strategies for Restricted Stock Units

   

1. Sell All Shares As Soon As Possible

 

This strategy may be ideal if the employee anticipates a decline in the share price.

It’s crucial to be aware that if you sell the shares within a six-month to one-year period, there will be a short-term capital gains tax, which is equal to the ordinary income tax rate. Waiting until after the first year will likely result in long-term capital gains tax, which is usually much lower.

 

2. Sell Only a Portion of Your Shares

 

Holding onto a portion of the shares while selling off a portion is another selling strategy. The employee can diversify the equity holdings while staying vested in the company. This is smart for CEOs who want to diversify their portfolios while maintaining a stake in their company.

 

3. Hold On to Your Shares

 

If the employee has an optimistic, long-term perspective of the company stock, they shall hold onto the stock for as long as they like. The intention is for the stock price to increase over time, creating wealth and preventing immediate taxation.

 

4. Systematically Sell the Shares 

 

Many top-level executives employ an index proxy technique that involves systematically offloading shares with the assistance of a seasoned financial advisor. This strategy works particularly well when the executive wants to diversify a large concentrated stock investment for risk management reasons.

 

5. Exchange Fund Strategy

 

The employee can choose an exchange fund strategy if they want to diversify the concentrated position but don’t want to sell the shares and pay capital gains taxes. An exchange fund aggregates the concentrated stock positions of many investors, creating a diversified collection of stocks that resembles an underlying, broad-based stock market index. You can swap your concentrated position for a partnership interest or share of the exchange fund, avoiding a taxable event.

 

Advantages and Disadvantages of Restricted Stock Units

 

There are pros and cons to owning RSUs. Here are some of the advantages of a restricted stock unit:

 

1. Simple Timeline 

 

The biggest benefit of RSUs, particularly compared to other forms of equity compensation, is their simplicity. There is  a simple timeline of events, which often appears as follows:

  1. The employer grants the RSUs (which is not a taxable event).
  2. The employee is taxed on the units’ value on the day the RSUs vest after satisfying the vesting conditions.
  3. The employer withholds the required income tax in part (or occasionally in whole).
 

2. Easy to Value

 

While some equity compensation estimates can be challenging, a restricted stock unit can be valued using a straightforward formula. Divide the number of RSUs granted by the stock’s current fair market value.

The value of the restricted stock unit can be calculated whenever the employee wants to. However, that value is merely an expectation for the future until the stock vests. Between now and the vesting date, there is a remote possibility that the value of the shares will stay relatively unchanged, but it’s generally more likely that it will fluctuate.

 

3. Clear Vesting Schedule

 

This means that for the restrictions to be withdrawn, the employee must fulfill certain requirements, after which the employee can claim the value of the shares.

From a financial planning perspective, the vesting schedule is crucial since it can help design a strategy for estimating/calculating the value of the RSU. Knowing the vesting schedule will enable the employee to make wiser choices regarding investments and taxes.

 

4. Taxes Will Be Withheld

 

If the employee fulfills the criteria for vesting, it is a taxable event. In this case, the employee will be responsible for paying income tax on the vesting date on the value of all the shares owned.

 

5. Flexibility

 

Employees can keep the RSUs (once they are vested) even after they quit the company. RSUs offer flexibility to employees, especially if the company is publicly traded.

 

6. Benefits for Employers

 

An RSU plan has relatively few administrative costs. The employer would not have to worry too much about where the shares are going because there are no actual shares distributed under the plan. RSUs also allow the company to postpone issuing shares until the vesting is finished. This aids in delaying the dilution of shares for the company’s current shareholders.

 

Disadvantages of a Restricted Stock Unit

 

There are some disadvantages to owning RSUs:

 

1. Tax Consequences

 

Finding the money to pay taxes could be challenging for some employees if the firm is private and unable to help reduce the tax burden. Employees with many double-trigger RSUs may be subject to a significant tax burden when a liquidity event happens and all the shares vest at once.

The number of shares relinquished may not offset the actual tax owed, even if the employer helps manage the taxes. Employees may face additional tax consequences when filing their taxes.

 

2. Uncertain Future

 

In the case of private companies, there will be an uncertain waiting period before the employee can sell and profit. Even though the ultimate reward may be attractive, it may also leave the employee dissatisfied if the company does not develop as planned.

 

The Difference Between RSUs and Employee Stock Options (ESOPs)

 

ESOPs and restricted stock units are two different things. RSUs are equities issued to employees without receiving any payment in return. However, there are some limitations on how soon you can sell these shares.

ESOPs are stock compensation plans that are available to employees. However, the employees are not immediately given the stocks. The employee is offered the choice to buy company shares at a set price and later time.

 

Conclusion

 

Like other types of equity compensation, restricted stock unit plans are company-specific. Employees must, therefore, read the plan agreement thoroughly, have any queries regarding it answered by the HR department, and seek the advice of financial advisors.

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