Restricted stock units: how it works and why it matters

Restricted stock units (RSU) is one of the many types of equity grants that companies use as a tool to attract and retain talent. With restricted stock units, instead of giving out shares of company stock outright, the company gives key employees the right to obtain shares in the future if they meet certain conditions like staying with the company for a set period of time.

The idea is that restricted stock units encourage employees to stick around since they have to remain employed to actually get the shares. This is why it's a good way to incentivize and motivate employees to play the long game. Once the restrictions lapse, the RSUs convert into actual shares of stock which they can hold or sell for cash, potentially generating significant financial gains.

Restricted stock units can be granted to both employees and non-employees, but for the purpose of this article, we're discussing RSUs from the perspective of employee equity. We will deep dive into what restricted stock units are, how they work, their benefits and tax implications, and answer frequently asked questions.

Let's dive in!

What are restricted stock units?

Restricted stock units (RSU) is a form of equity-based compensation commonly used by companies as a talent acquisition and retention tool. When a company grants RSUs, the recipient does not own anything at the time of grant. Instead, the company promises shares of company stock that they will acquire at a future date or upon the fulfilment of certain vesting conditions.

The employee really doesn't own anything until vesting conditions are met. They're a shareholder with restrictions. They can't vote, they usually can't receive dividends. So they don't really have any kind of the rights and features of a full shareholder until those vesting conditions are met.
^{—Matt Secrist, Compensation & Benefits Partner at Taft Law}

Aside from continued employment, vesting conditions may also involve meeting certain performance milestones.

With RSUs, you're getting a grant of shares that is subject to restrictions. Typically, it's a vesting schedule that sets forth like a service requirement. So you have to work 4 years, you vest 25% each year. That's what I typically see.

We also see restricted stock grants where you have to meet some kind of performance condition. Say, you have to help apply for a patent or you have to reach certain sales goals in order to become vested.
^{—Matt Secrist, Partner at Taft Law}

RSU vs stock options

If you're familiar with stock options, you know that they are a type of equity where the recipients are given a right to purchase company stock at a predetermined exercise price. With RSUs, employees receive actual stocks without having to buy them. Once RSUs vest, the shares have immediate value that can be sold right away for cash. However, with stock options, you must exercise the options to buy shares.

Early stage vs later stage companies

Restricted stock units are more common in later-stage companies whereas stock options tend to make more sense in the early stages. In many cases, startups who offer stock options in their earlier stages switch to restricted stock units as they grow.

Early stage startups. RSUs may be less common in startups due to the higher level of risk involved. In the early stages, RSU grant sizes may be smaller compared to those in the later stages. Since the company's valuation is lower, the value of the RSUs at the time of grant may not be as substantial.

Later stage companies. In later stage companies, RSU grants tend to be more generous due to the higher valuation of the company. As the company achieves milestones and grows in value, the RSUs become more valuable, providing employees with a compelling incentive to stay with the company.

Private vs public companies

The key difference between RSUs in public and private companies lies in the liquidity of the shares:

Private Company: For employees in private companies, selling RSU shares requires waiting for a liquidity event, such as an acquisition, merger, or IPO. Sometimes, if the company permits, employees may find a third-party buyer to purchase their RSU shares.

Public Company: In a public company, once vesting conditions are met, employees can sell their shares immediately on the open market. However, they must comply with the company's trading policy, which may restrict trading during certain periods of the year.

In summary, RSUs in public companies offer more immediate liquidity, allowing employees to sell their shares as soon as they vest. On the other hand, private company RSUs involve waiting for specific events or finding a willing buyer to access the value of the shares.

Pros and cons of RSUs

RSUs can be very valuable for both employers and employees for a few key reasons:

• Simplicity. RSUs are easier to understand and administer compared to stock options, as employees receive shares outright without an upfront cost.
• No upfront cash out. RSUs do not require employees to pay an exercise price or buy shares, making them financially attractive.
• Potential for value for appreciation. RSUs have the potential to increase in value if the company's stock price rises, providing employees with the opportunity for substantial gains.
• Tax benefits. RSUs may offer tax advantages, when employees are taxed at the time of vesting based on the fair market value of the shares. Any subsequent capital gains may receive preferential tax treatment.

Just like any equity incentives, RSUs do come with risks.

• Limited liquidity. For employees in private companies, realizing the value of RSUs may require waiting for a liquidity event, such as an IPO or acquisition.
• Tax implications. RSU vesting triggers taxable events, which can lead to tax liabilities, even though employees may not have received any cash to cover the taxes owed.
• Risk of stock price decline. If the company's stock price drops after RSU vesting, employees may experience a decrease in the value of their vested shares.
• Dependency on company performance. RSU value is tied directly to the company's stock performance, leaving employees vulnerable to adverse market conditions beyond their control.

It's essential for employees to understand their company's RSU program and seek financial advice to make informed decisions aligned with their long-term financial goals.

How do restricted stock units work

There are four stages in the lifecycle of an equity grant: (1) Grant, (2) Vesting, (3) Exercise, and (4) Exit. Restricted stock units follow the same cycle. Let's break it down:

1. RSU grant

Just like other equity compensation, restricted stock units are offered as part of employee compensation, benefits, or promotion package.

There are important terms that have to be determined in order to initiate the agreement. This includes all the essential details of the RSU grant, such as the number of units, vesting condition, qualifying provisions, and any other terms and conditions. Take note that, while stock options have exercise price, RSU grants do not.

Like any employee equity agreement, the RSU agreement serves as a binding contract between the employer and the employee. It's highly recommended that you consult with legal and accounting experts to make sure that your grant agreement covers everything.

2. Vesting conditions

One crucial component of restricted stock units is its vesting component as it dictates the triggers on which the RSUs become fully transferable to the employee.

RSUs typically vest on the passage of time, fulfilment of performance criteria, or a combination of both.

• Time-based vesting. When RSUs vest via instalments over a certain number of years, usually over a 4-year vesting period. For example, a company may grant an employee 1,000 RSUs that vest over 4 years at a rate of 25% per year. That means after 1 year, 250 shares would vest; after 2 years, another 250 shares; and so on until all 1,000 shares have vested.
• Milestone-based vesting. Some RSUs vest upon achieving specific company goals (like an IPO or an acquisition), hitting performance targets, or completing project milestones. For example, an employee might need to apply for a certain patent, or reach a specific sales goal. RSUs vest when these targets are achieved.
• Hybrid vesting. This is a combination of time-based and milestone-based conditions. For example: Early vesting can be considered when a certain performance target is met.

These vesting conditions are why restricted stock units are ideal for talent acquisition and retention. It incentivizes employees to play the long game and to work hard towards the set milestones.

3. Exercising RSU

As earlier discussed, exercising restricted stock units is quite different from exercising stock options since employees don't need to pay cash to convert RSU to shares. They convert to shares as vesting conditions are met.

Exercising restricted stock units, therefore, means either  (1) selling them for cash or (2) holding onto them as investment for potential appreciation. There are different strategies to understand to make informed decisions about exercising RSUs.

Hold and diversify

Once RSUs vest, employees have the option to hold the company's stock or sell it. This decision depends on various factors, including their financial goals, company's stock performance, or risk tolerance.

Holding onto vested RSUs allows employees to gradually diversify their investment portfolio over time. By retaining the shares, they become shareholders of the company, and their financial success becomes aligned with the company's performance.

If you are granted RSU and believe in the company's long-term potential and anticipate stock price appreciation, this strategy can be beneficial.

Sell to cover taxes

When exercising RSUs, employees may incur tax liabilities due to the gained value. With the "sell to cover" strategy, they sell a portion of the vested shares to cover the taxes, while retaining the remaining shares.

By selling some shares, they generate enough funds to pay the taxes owed on the RSU gains. And by retaining some shares, they can still keep a portion of the RSU shares, allowing they to benefit from potential future stock appreciation.

4. Exit

Upon an exit event, such as an IPO, merger, or acquisition, the treatment of RSUs depends on the terms outlined in the RSU grant agreement and the company's policies. Here are some possible scenarios with an exit event:

• Cash buyout or stock conversion. In some cases, if the company is acquired or goes public, the RSUs may be converted into cash or company shares, respectively, based on the terms of the exit event. The value of the cash or shares received will be determined by the terms specified in the RSU grant agreement and the exit event's valuation.
• Accelerated vesting. An exit event can trigger accelerated vesting of RSUs, meaning that all or a portion of the unvested RSUs may become fully vested. This is often done to provide employees with immediate ownership or liquidity options in light of the company's change in status.
• Continued vesting with new terms. In some cases, RSU holders may continue to vest in their RSUs according to the original schedule, even after the exit event. However, the terms and conditions of the RSUs might be modified to reflect the changes resulting from the exit event.

There may also be scenarios that are less favorable, like an employee leaving or terminated before the RSUs vest. In cases where the termination happens before vesting conditions are met, the unvested RSUs are typically forfeited.

In any case, it's essential for RSU holders to carefully review their RSU grant agreements and consult with their company's HR department or legal counsel. Each exit event is unique, and the treatment of RSUs can vary widely depending on the circumstances of the event and the company's policies. Being informed about the potential outcomes will help RSU holders make well-informed decisions regarding their equity compensation during the transitional period of an exit event.

There are many other strategies to maximize the value of RSUs. Consider consulting with financial advisors or tax professionals who specialize in stock-based compensation.

In this on-demand webinar, Matt Secrist, compensation and benefits expert at Taft Law, talked about RSU in comparison to stock options, tax implications, and the importance of understanding 83(b) elections in connection to RSU.

Tax implications of RSUs

When an employee receives restricted stock units (RSUs) as part of their compensation, it’s important to understand their tax implications.

Vesting tax

RSUs are taxed when they vest, not upon receiving them. At vesting, the fair market value of the shares at that time will be considered ordinary income. That income is subject to federal income taxes, social security taxes, and medicare taxes. The taxes are withheld from the employee's paycheck or they may need to pay estimated quarterly taxes.

If the shares increase in value between when they receive the RSUs and when they vest, they could face a sizable tax bill. Some companies allow employees to sell shares right away to cover taxes, but not always. It's important to consider planning ahead in order to pay taxes due at vesting.

Capital gains tax

After the RSUs vest and the employee pays income taxes on them, any future gains when they sell the shares are taxed at the capital gains rate.

When you pay capital gains tax, take note that the capital gains rate is often lower than ordinary income tax rates. However, you must hold the shares for at least one year after vesting to qualify for the long-term capital gains rate.

Local tax laws

Depending on the country and local tax laws, an employer may withhold taxes on the RSUs when they vest. Tax laws can change, and they can significantly impact the tax treatment of RSUs. Staying informed about tax regulations will help make informed decisions about when to exercise RSUs.

RSUs can be a great way to build ownership in a company, but make sure to go in with eyes open to the tax consequences. Talk to your company’s finance or HR department if you have any questions about when your RSUs will vest and what taxes may be due. Planning ahead can help avoid an unexpected tax shock and allow you to maximize the potential benefits of your RSUs.

So there you have it, the basics of how restricted stock units work and why they should matter to you. While the taxes and restrictions can be overwhelming, RSUs provide an opportunity to share in your company’s success over the long run. Pay close attention to the details of your company’s RSU plan and take advantage of resources to make the most of this benefit.

With time and patience, those RSUs could turn into a nice nest egg that provides financial freedom and flexibility. Not a bad deal if you can get it!

FAQs about restricted stock units

Here are some common questions and answers about RSUs:

When do I receive the shares?

You earn the right to the shares as your RSU vests according to the vesting conditions set by your company. This happens typically in instalments over a period of 4 years. If you leave the company before the vesting date, the unvested RSUs are usually forfeited.

Do I have to pay anything for the RSUs or shares?

No, RSUs are granted to you at no cost. Once the RSUs vest, you receive the shares for free. However, when the shares are delivered, their value counts as taxable income. You'll owe income taxes on the fair market value of the shares at vesting.

Can I sell the shares once they vest?

Yes, once RSU shares vest and are delivered to you, they're yours to keep or sell as you choose. Many employees sell a portion of the shares to pay income taxes, then keep the rest as an investment. However, there may be restrictions on when you can sell the shares, known as a "holding period." Check with your company's stock plan for details.

Do RSUs provide ownership in the company?

Not exactly. While RSUs provide the right to stock, you don't actually become an owner or shareholder until the shares vest and are issued in your name. At that point, you'll have voting rights and receive dividends, if any, just like any other shareholder.