Restricted Stock Units (RSU) – What Are They and How They Work
Restricted stock units are a form of compensation offered to employees that award shares in a company once certain metrics are met. These stock units are offered to retain skilled workers and incentivize long-term commitment to the company, and can be an extremely valuable asset for employees who remain with the company long enough to capitalize on them.
Key Takeaways
- Restricted stock units are a form of stock-based compensation awarded to employees based on time- and performance-based metrics.
- Some RSUs are transferred when an employee has worked at a company for a certain period of time, while others are conferred upon achievement of certain performance goals or an initial public offering at the company.
- RSUs are taxed immediately upon being distributed to their owner, requiring the employee to satisfy tax obligations in the same year they receive their stock.
- RSUs are more common in larger, more stable companies compared to stock options, which are more popular with younger companies anticipating rapid expansion in the near future.
What Is a Restricted Stock Unit (RSU)?
Restricted stock units are shares in a company offered with a delayed fuse. Before an employee can cash in their RSUs, certain conditions must be met relating to either time or stock performance.
An easy way to understand RSUs is to think of them as a conditional promise of stocks made by an employer to an employee. If the employee remains with the company for the agreed upon length of time, or if the company meets the specified performance benchmarks, then the employee will receive the agreed upon amount of stock at no additional cost.
History of RSUs
Restricted stock units have become a very popular form of employee compensation in the past 20 years, especially among larger, more stable companies who do not anticipate major short-term fluctuations in their stock valuation.
Prior to 2006, many companies preferred to offer stock options instead of RSUs. Unlike RSUs, which are offered to employees at no cost, stock options allow employees to purchase stock at a price lower than what the company projects them to be worth in the future. This was offered as an incentive when recruiting talent, and in cases where the company’s stock value exploded it could be incredibly lucrative for employees.
Stock options also had a major upside for employers in the period leading up to the bursting of the dot-com bubble, as companies were not required to report the value of these stock options as expenses prior to 2006. As long as the options were offered at the market value of the stock, companies could offer massive compensation packages based around these options without reporting them as expenses, thereby keeping the business’ reported earnings significantly higher.
In 2006, guidance issued by the Financial Accounting Standards Board was adopted nationwide requiring this loophole be closed to improve the comparability of businesses using stocks as a form of compensation. Once this major incentive for stock options was eliminated, many companies switched over to offering RSUs or another, similar, form of equity-based compensation known as restricted stock awards.
This move reflected the ongoing trend already visible among major companies at the time. Microsoft famously switched from stock options to RSUs in 2003, signaling a major shift in accounting and compensation practices.
Types of RSUs
All RSUs have metrics, known as triggers, which must be met before the stock is transferred to an employee—a process known as vesting. There are two types of RSUs, and which variety your company offers will determine how and when the stocks vest.
Event-based vesting (double-trigger RSUs)
Double-trigger RSUs are the most common form of RSU offered by companies, and they require two conditions to be met.
The first condition is based on time, requiring the employee to remain employed at the business for a predetermined period before the stocks fully vest. The second condition is typically event-based, contingent on the company being sold, acquired, or undergoing an initial public offering. This type of transfer is known as an “exit event.”
If an employee remains with the company for the allotted period of time prescribed by the RSU, and is still employed at the company at the time of the exit event, their RSUs will fully vest and confer all the benefits of traditional stocks to the employee.
Time-based vesting (single-trigger RSUs)
While double-trigger RSUs are more popular in general, there are many cases in which the second, event-based trigger requirement makes an RSU unappealing. In these cases, companies can offer single-trigger RSUs that only require a certain length of time employed at the company to fully vest their RSUs.
This sort of situation is more common in cases where the company is unlikely to be acquired or undergo an IPO. This is more typical in larger companies and businesses which are already publicly traded.
Performance-based vesting
Rather than triggering through an exit event like an acquisition, performance-based vesting requires certain performance metrics and company goals be met before the RSUs are vested. This type of vesting is flexible, and can be linked to individual employee performance or company-wide goals outlined by leadership at the outset of the RSU distribution. This type of vesting could be more appealing to employees who seek compensation linked to their impact on the company, rather than the length of their tenure with the business.
Advantages of RSUs
Restricted stock units have several key advantages over other stock-based compensation packages like stock options. These include:
Guaranteed value. While stock options are only worth something if the company’s stock value exceeds the strike price outlined in the stock option package, RSUs will always contain some value. Even if the company’s stock price declines, the stocks can still be sold once they are vested.
No cost to employee. While stock options require the employee to pay into the company at the strike price defined in their compensation plan, RSUs are given free of charge to employees. The only expense placed upon the RSU’s recipient occurs when the stocks vest and the employee must pay taxes on them.
Simplicity. RSUs are one of the most straightforward forms of employee stock compensation. The requirements to vest the stocks are outlined at the outset of the employee’s tenure, and once those conditions are met the stocks are vested. There is no guesswork related to exercising stock options at the right time or in the right way, the stock is simply awarded to the employee at the agreed upon time.
Disadvantages of RSUs
While RSUs are a popular form of compensation for employers and employees both, they aren’t always the best option for everyone. This type of compensation plan has a few key disadvantages to consider, including:
Tax liability. As soon as the shares are vested, the employee is on the hook for taxes related to the income. Because this tax obligation can be quite high in certain cases, many employees opt to sell some portion of their RSUs immediately after they vest to cover the expense.
Inflexibility. While stock options can be exercised at a time when the tax obligation makes the most sense for an employee, RSUs vest as soon as the agreed upon metrics are met. This means that an employee might find themselves facing significant tax obligations at an inopportune time, complicating their financial situation unexpectedly.
Forfeiture risk. RSUs are only valuable if the employee and company meet the agreed upon vesting requirements. If an unexpected life change forces the employee to leave a company before the RSUs vest, or the company never undergoes an exit event or hits performance requirements for vesting, then the RSUs are essentially valueless in many cases.
Tax Implications of RSUs
As soon as an RSU vests, the owner of the shares is obligated to pay taxes on the income. This income is treated as supplemental income, and is subject to standard federal income tax, payroll tax and any applicable state and local taxes.
Because employees do not usually have control over when the requirements for vesting are met, a popular strategy for reconciling these tax obligations is a process known as “sell-to-cover.” Under this system, the employee’s tax obligation is calculated at the time the RSUs vest and whatever amount of stock is necessary to cover this obligation is sold as soon as it is available to do so. This leaves the remaining RSUs untouched and ensures the employee is not hampered by tax obligations at the end of the year.
Any RSUs that remain after this process is completed are treated just like any other stocks for tax purposes, and are subject to capital gains taxes as though they were purchased in the same way as traditional stocks.
Bottom Line
Restricted stock units are a great way for companies to attract and retain talent, incentivizing long-term commitment to the business in exchange for significant financial compensation. While it’s important to understand what your tax obligations look like up front with RSUs, employees can benefit greatly from an equity-based compensation package that includes these types of restricted stocks. Under the right circumstances, these packages can be mutually beneficial for employees and employers and contribute to both companies and workers achieving their long-term financial goals.
Restricted Stock Units FAQ
What happens to RSUs if you leave a company?
Generally speaking, if an employee leaves a company before their time-based or event-based RSUs vest, they are forfeited. There are some situations in which a company can waive the second trigger in a double-trigger RSU, but typically, it’s best to remain with a company until your RSUs vest if possible.
What is a vesting schedule for RSUs?
There are two ways in which RSUs can be vested. Graded vesting is a schedule under which ownership of stocks is gradually transferred to the employee over time, with full vesting occurring after all the prescribed conditions are met. Cliff vesting, on the other hand, confers full control of the stocks all at once after the requirements are satisfied. Some companies use one or the other, but it is common to use a hybrid approach that distributes portions of the RSUs at certain benchmarks along the way to full vesting.
Can you sell RSUs immediately after they vest?
Yes, and in many cases it’s necessary to satisfy tax obligations. RSUs are non-transferable prior to vesting, but once they vest they are treated just like any other stock owned by the employee.
