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Restricted Stock Units: a closer look at equity compensation strategies

ARTICLE | September 14, 2023

In today's competitive job market, companies constantly seek ways to attract and retain high-quality employees. One approach that has gained popularity in recent years is using Restricted Stock Units (RSUs), a form of equity-based compensation that offers employees a stake in the company's future growth. 

Understanding the nuanced differences between RSUs, restricted stock awards (RSAs), and stock options is crucial for both companies and employees. While these three forms of equity compensation share a common goal - aligning the interests of employees with those of the company - they function differently and carry varying benefits and implications. 

Factors such as the company’s stage of growth, stock price, and the tax implications for employees can all influence which form of equity compensation is most advantageous. As such, careful consideration and understanding of these forms of equity-based compensation can help employers make informed decisions when creating an effective compensation strategy. 

What are RSUs?

Restricted Stock Units are a form of compensation granted to an employee in the form of company shares. RSUs are typically subject to a vesting schedule, which means that the shares do not fully belong to the employee until they have met certain time or performance-based criteria. During the vesting period, the shares cannot be sold, and they are considered an unfunded promise to pay at the share price when they eventually vest.

When a company offers RSUs to employees, it is generally an incentive to encourage them to stay with the company and contribute to its success. If the company performs well and its stock price increases, the value of the employee's RSUs will also increase, creating a win-win situation for both parties.

The vesting schedule for RSUs can vary, but it often involves the gradual release of shares to the employee over a certain number of years. For example, an employee might be granted 1,000 RSUs, with 200 shares vesting each year over a five-year period. As the shares vest, their Fair Market Value is added to the employee's taxable income for that year, and the employee pays ordinary income tax on that value.

Once vested, an employee can choose to sell their shares, hold onto them, or sell some and keep others. At this point, the shares function like any other stock in the employee's portfolio. If the shares increase in value after vesting and are then sold, the employee will pay capital gains tax on the difference between the Fair Market Value at the time of vesting and the sale price.

Benefits of RSUs

Companies choose to issue RSUs for various reasons, particularly as they mature and their share price increases. RSUs can be advantageous in the following ways: 

  • Simplicity: RSUs are easier to understand and manage compared to stock options, making them more attractive to employees who may not be familiar with the intricacies of equity compensation. 

  • Retention: RSUs serve as a powerful retention tool, as employees are more likely to remain with the company to receive their promised shares. 

  • Tax advantages: For employers, RSUs are generally tax-deductible as a business expense, similar to other forms of employee compensation.

Comparing RSUs, Restricted Stock Awards (RSAs), and Stock Options

While RSUs, RSAs, and stock options all offer employees a stake in a company, each has unique features and implications for both employees and the company. 

Stock options

Stock options provide employees with the right, but not the requirement, to buy a certain number of shares in the company at a predetermined price (known as the “strike price”) within a set timeframe. This is advantageous if the company’s stock price increases above the strike price, allowing the employee to buy the stock at a discount and potentially make a profit. However, the options become worthless if the company’s stock price does not exceed the strike price within the set timeframe. 

These options tend to be most advantageous when a company enters its growth phase, as they allow employees to benefit from the company’s success. They also provide flexibility in tax treatment, adding to their appeal. However, as the company matures and the strike price becomes potentially unaffordable for employees, other forms of equity compensation, like RSUs, might be more appropriate. 

Restricted stock units

Unlike stock options, RSUs have no strike price, meaning the shares are worth their full market value upon vesting. This means that RSUs will always have value at vesting unless the company’s stock price falls to zero. 

The FMV of vested RSUs is treated as compensation and considered taxable income when they’re delivered, essentially acting as a bonus paid in company shares. RSUs are often offered by later-stage, mature companies with a high FMV, making them a viable tool for incentivizing employees once stock options become less accessible. 

Restricted stock awards

RSAs are grants that offer employees the right to receive shares immediately, but these shares are subject to restrictions and a vesting schedule. Like RSUs, RSAs do not have a strike price, but unlike RSUs, RSAs grant employees ownership immediately. This immediate ownership gives employees the right to vote and receive dividends during the vesting period. 

Employees who leave the company before the shares vest typically forfeit their RSAs back to the company. For tax purposes, unless the employee opts for the 83(b) election to be taxed at grant, RSAs are taxed as ordinary income as they vest, similar to RSUs. 

RSAs are often offered by very early-stage companies with a low FMV. This allows employees to have ownership in the company without a significant initial financial outlay or tax burden, assuming they receive the shares as compensation instead of purchasing them outright. By offering high upside potential, RSAs can help startups compete for talent against larger companies that can pay higher salaries. 

This article is intended to provide a brief overview of restricted stock units. It is not a substitute for speaking with one of our expert advisors. For more information, please contact our office.

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