In the realm of employee compensation, Restricted Stock Units (RSUs) have become increasingly popular. These equity awards are often offered as part of a compensation package, especially in the tech industry and startups, to attract and retain top talent.
RSUs can be complex. Understanding their pros and cons is crucial for employees who receive them.
Let’s delve into the basics of RSUs, how they operate, and the advantages and disadvantages they bring to employees.
What are RSUs?
RSUs are a form of equity-based compensation a company grants to its employees. RSUs represent the value of company stock, but they don’t represent actual shares until they vest. If you were to leave your employer or the requirements are not met, your unvested RSUs may be forfeited.
How do RSUs work?
Once RSUs vest, the employee receives the shares and can either hold onto them or sell them. Employees are subject to ordinary income tax on the fair market value of the shares at the time of vesting. Vesting can vary depending on whether your employer is a private company or already public. Pre-IPO companies may be subject to a double-trigger provision. Typically, one part is time and the other “trigger” can be some sort of event; IPO or acquisition. Depending on if certain criteria is met, one could be eligible for Section 83(b) election allowing the ordinary income tax to be paid when the shares are granted versus vested.
Let’s say a company grants an employee 1,000 RSUs with a vesting period of three years. After three years of service with the company, the RSUs vest, and the employee receives 1,000 shares of company stock. If the stock trades at $50 per share at the time of vesting, the employee would recognize $50,000 of ordinary income and owe taxes on that income.
Vesting schedules for RSUs can vary widely. Some RSUs vest over time, with a portion of the RSUs vesting each year. Others may have performance-based vesting criteria, such as achieving certain company milestones or targets. Once RSUs vest, they are typically subject to a holding period before they can be sold.
RSUs vs. Stock Options
RSUs and stock options are equity compensation options that companies offer their employees. There are critical differences between the two.
RSUs are actual company stock shares granted to employees, typically subject to a vesting schedule. Once the RSUs vest, the employee receives the shares outright. The value of the RSUs is determined by the stock price at the time of vesting. RSUs provide employees with ownership in the company, and they have voting rights.
Stock options give employees the right to purchase company stock at a predetermined price, known as the exercise price or strike price. Stock options usually have a vesting period as well. If the stock price increases above the exercise price, employees can exercise their options and buy the stock at a lower price, making a profit. However, if the stock price doesn’t rise above the exercise price, employees may choose not to exercise their options.
One significant difference is that RSUs have value even if the stock price doesn’t appreciate, but stock options only have value if the stock price increases.
RSUs also carry less risk for employees because they receive shares outright, regardless of whether the stock price goes up or down.
Tax treatment also differs between RSUs and stock options. RSUs are taxed as ordinary income when they vest. Taxation of employee stock options that aren’t traded on the open market depends on whether they are non-qualified or incentive stock options. The taxation of these employee stock options is complex. You should seek the guidance of a qualified financial advisor, CPA or a financial advisor who is also a CPA.
Advantages of RSUs
Alignment of interests: RSUs align the interests of employees with those of shareholders because the value of the RSUs are tied to the performance of the company’s stock.
Retention tool: RSUs can be a powerful retention tool because they typically vest over time. This means that employees who receive RSUs are incentivized to stay with the company for a certain period to receive the full value of their RSUs.
Potential for stock price appreciation: Since RSUs are tied to the company’s stock price, there is the potential for employees to benefit from any increase in the stock price.
Disadvantages
Lack of liquidity: One of the main disadvantages of RSUs is their lack of liquidity. Unlike stock options, which can be exercised at any time (subject to the vesting schedule), RSUs cannot be sold until they vest. This means that employees may have to wait several years before realizing the value of their RSUs.
Tax implications: While RSUs can provide employees with valuable compensation, they also come with tax implications. When RSUs vest, the value of the vested shares is considered ordinary income and is subject to income tax. This can result in a significant tax liability for employees, especially if the value of the RSUs is high. If the RSUs are subject to a double trigger provisions, a large tax bill could be due at once after the conditions are met.
Risk of forfeiture: RSUs are typically subject to forfeiture if employees leave the company before they vest. This means that employees who receive RSUs may not receive the full value of their award if they leave the company before all their RSUs vest.
Final Thoughts
RSUs can be a valuable form of employee compensation, offering a direct link to the performance of the company’s stock and serving as a powerful retention tool. However, they also have disadvantages, like lack of liquidity and tax implications. Employees who receive RSUs should carefully consider these factors and consult with a financial advisor to understand the full impact of RSUs on their financial situation.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. All investing involves risk, including loss of principal. No strategy ensures success or protects against loss.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. LPL Financial does not offer tax advice or services.