Restricted Stock Units: All You Need to Know About RSUs

Are Restricted Stock Units (RSUs) the right vehicle for your long term incentive (LTI) program? Depending on your needs, RSUs can be an effective way to lure new talent and promote long term loyalty in your key employees. In this article we give you everything you need to know: what they are, when they make sense, and the pros and cons.

RSUs are a form of equity compensation that grants employees stock shares once certain, predetermined conditions are met. Through RSUs, employees are given the right to acquire shares, but limitations and requirements, such as vesting periods, must be fulfilled before full ownership of the shares is gained.

As with other long-term incentives (LTIs), RSUs are designed to reward employee contributions and incentivize long-term collaboration with the company. By tying employee performance with organizational success, RSUs help to align employees’ interests with those of the company’s shareholders. 

With a promise of receiving stock shares in the form of RSUs, the workforce is encouraged to engage in behaviors that promote growth, profitability, and sustainability throughout an organization. 

Discover the types, benefits, drawbacks, and tax implications of RSUs to learn whether they are a suitable alternative to traditional stock options and how they can contribute to your organization.

History of RSUs

RSUs surfaced as a simpler and more effective alternative to traditional stock options, and their introduction marked a shift in the approach to employee compensation. 

The adoption of equity compensation was prominent in the early 1990s, particularly among emerging tech firms. These firms, with financial constraints, began relying on offering non-cash compensation to attract and retain employees, with their own equity being the primary form of valuable currency. 

However, cash restrictions weren’t the only reason that organizations turned towards RSUs. In the early 2000s, several leading companies, including Microsoft, participated in the transition for their own benefit. During the following years, the reliance on stock options diminished, while RSUs played an increasingly pivotal role in the new era of equity distribution.  

Types of RSUs

Organizations can offer employees RSUs with different conditions to align incentives, manage risk, and optimize tax outcomes. Here are the most common types of RSUs to tailor to your specific organizational objectives: 

Time-based vesting (single-trigger RSUs)

Single-trigger RSUs operate on time-based vesting schedules, which require employees to work for the company for a specified period before gaining access to the stock units. When the condition has been met, a triggering event occurs, in which employees are granted full ownership of the RSUs or their cash equivalent. 

Single-trigger RSUs simplify the vesting process by only requiring one condition to be met. A straightforward vesting structure provides clarity and transparency for employees. Since they have a clear understanding of when they will gain access to their equity compensation, such employees will feel more confident about the value of their equity compensation. 

Examples of single-trigger RSUs

An employee is awarded 600 RSUs with a four-year vesting period. After the vesting period is completed, the RSUs automatically convert into shares of company stock, granting the employee full ownership.

Through graded vesting, RSUs vest incrementally over time in equal portions. An employee receives ownership of 25% of the RSUs each year, gradually reaching full ownership of all 600 shares by the end of the fourth year.

Cliff vesting involves an initial waiting period, usually lasting one year, during which no RSUs vest. Following the end of the cliff period, a large portion of the 600 RSUs vests all at once. Any remaining RSUs may vest based on a predetermined time-based schedule.

Performance-based vesting (double-trigger RSUs)

Double-trigger RSUs require two specific events to occur for the RSUs to vest. The first condition is typically performance-based or time-based, similar to single-trigger RSUs. The second vesting requirement is an exit event, such as an acquisition or an IPO, or is tied to another significant event, such as a specific company performance milestone. The RSUs remain in a state of vesting until both triggers occur.

Double-trigger RSUs under performance-based vesting conditions can be beneficial for organizations by further aligning employee and company interests. However, the practice can lead to additional uncertainty for employees, as their shares may not vest if the second requirement is not filled for reasons beyond their control. 

Examples of double-trigger RSUs

An employee is granted 1000 RSUs with a four-year vesting period. Once they have been with the company for four years, the RSUs will have met the first time-based vesting condition. If the company is acquired by a larger organization and the employee is still with the company, the second event is triggered, and the remaining unvested RSUs fully vest at the time of acquisition.

If the organization achieves $100 million in annual revenue within seven years, the vesting of 50% of the RSUs is triggered. In the event of the organization’s transition to public status through an IPO, the unvested RSUs would automatically vest in full upon the IPO event, granting full ownership to the employee.

Tax implications of RSUs

RSUs are typically subject to taxation as ordinary income upon vesting, calculated based on the fair market value of the shares on the vesting date. Employees are accountable for income tax payments, including employment taxes, corresponding to the value of the vested RSUs. Any capital gains arising from the sale of these shares are then subject to capital gains tax.

Companies may be eligible to claim tax deductions related to RSUs, particularly for the compensation expense associated with granting them. However, the availability of these deductions can vary depending on factors such as the company’s tax jurisdiction and the specific terms of the RSU grants.

For multinational companies, RSUs granted to employees in different countries pose complex tax challenges related to cross-border taxation, foreign tax credits, and tax treaties. Companies must perform their due diligence related to varying tax laws between countries to ensure compliance with regulations and avoid penalties. 

Benefits of RSUs

RSUs can be a suitable option for companies that aim to simplify the compensation process, motivate employees, and effectively manage equity compensation programs. The top benefits of RSUs include: 

• Simplicity: RSUs are generally simpler to understand and administer compared to stock options. They have straightforward vesting schedules, eliminating the need for employees to exercise options and purchase shares.
• Retained value: RSUs retain value even if the company’s stock price declines after the grant date. Unlike stock options, which may become worthless if the stock price falls below the exercise price, RSUs continue to have value based on the fair market value of the company’s stock.
• Delayed stock dilution: RSUs help defer the issuance of shares until a later date, which, in turn, delays stock dilution to existing shareholders. Delayed dilution can benefit companies that aim to avoid immediate impacts on ownership percentages while offering employees equity compensation.
• Pay equity: RSUs contribute to promoting pay equity within organizations. By offering RSUs as part of compensation packages, companies ensure that employees are rewarded based on their contributions and performance rather than solely on their base salary. 
• Employee ownership: RSUs provide employees with a sense of ownership and pride in their role, which can increase their satisfaction levels. A motivated workforce that is invested in the company’s future and success can result in higher retention rates and lower turnover costs.

Drawbacks of RSUs

Although RSUs can benefit both companies and employees, this form of compensation has several drawbacks organizations must consider before implementation:

• Lack of flexibility: RSUs typically have fixed vesting schedules and conditions, offering little flexibility compared to other forms of equity compensation, such as stock options. RSUs’ lack of flexibility can limit a company’s ability to customize their compensation packages to suit the individual needs or preferences of employees.
• Tax liability: RSUs can create tax liabilities for employees upon vesting, which can reduce the net value of the RSUs granted by companies and may require employees to set aside funds to cover their tax obligations.
• Shareholder dilution: As with other forms of equity compensation, issuing RSUs can lead to dilution of existing shareholders’ ownership stakes in the company.
• Lack of voting rights: Unlike shareholders who directly own company stock, RSU recipients generally lack voting rights or other privileges until the RSUs have vested. A lack of influence over company affairs may deter some employees from fully embracing RSUs as an adequate form of compensation. 
• Uncertain future: The value of RSUs is tied to the performance of the company’s stock, which can be subject to market volatility and uncertainty. Employees who are offered RSUs may be hesitant to accept due to the risk that the RSU’s value declines or even becomes worthless if the company’s stock underperforms.

Stock options vs. RSUs: Which is better?

Stock options are a highly common and well-known form of equity compensation. Unlike RSUs, stock options allow employees to purchase shares in their company’s stocks at a predetermined price. These stock options have an exercise period during which employees can exercise their options to purchase shares at the predetermined price, usually referred to as the strike price.

Stock options present an opportunity for substantial returns if the company’s stock value rises over time. However, employees must also assume the risk of the stock price not increasing or even declining. In contrast to RSUs, which can be subject to capital gains tax, stock options are treated as regular income and may only be subject to such tax when they are exercised and the underlying stock is subsequently sold.

When to use stock options

Stocks are best suited for smaller companies and early-stage start-ups that have the potential for significant growth but are currently in their early stages of development. 

Stock options can instill a sense of ownership and entrepreneurial spirit among employees, as they will have a stake in the company’s future success. This can lead to increased dedication, innovation, and commitment to achieving the company’s goals, which is particularly valuable in the dynamic and high-growth environment of start-ups.

Employees are responsible for exercising the option to own stock, allowing them to decide when to purchase company shares. The stock option’s additional flexibility can be advantageous from a tax perspective, as employees can potentially optimize their tax liabilities by strategically timing the exercise of their options.

As a result, companies can offer stock options as a means of attracting high-quality talent and competing with more established firms without having to offer high cash salaries, bonuses, or other incentives that may strain their limited financial resources. 

When to use RSUs

RSUs are an optimal choice for companies such as late-stage start-ups and public companies. Unlike stock options, which can dilute existing shareholders when exercised, employees are not issued new shares during the vesting process of RSUs, which is particularly advantageous for public companies where managing dilution is an immediate concern.

Through RSUs, the employee does not need to take any action to obtain stock. Rather than needing to purchase their shares, they receive them automatically when vesting conditions are met. Similarly, unlike stock options, which often require employees to make a stock purchase, RSUs are typically granted to employees at no cost. The ease of access and lack of upfront financial commitment associated with RSUs can be especially beneficial for companies with employees who may not have the financial means to exercise stock options.

Conclusion

RSUs offer several advantages for companies, such as delaying share dilution, aligning employee and shareholder interests, and promoting pay equity. While this form of equity compensation can be advantageous, it’s not suitable for all organizations. In some cases, stock options may prove to be more effective at achieving the company’s desired outcomes

Before implementing RSUs, companies must thoroughly understand their advantages, drawbacks, and tax implications so the process can be properly executed and aligned with organizational goals. 

Utilize advanced pay equity software and workforce analytics systems to ensure that RSUs are structured to meet the company’s strategic objectives and appropriately reward employees for their contributions. Get in touch with us at beqom to speak to an expert and discover how our compensation management solution can help you manage restricted stock units and other long term incentives.