Restricted Stock Units Made Simple (Part 1): Understanding The Core Concepts
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Several years ago, when companies began exploring alternatives to stock options for their broad-based grants of equity compensation, the type of grant most often bruited about in corporate circles was restricted stock. In fact, many observers foretold that restricted stock would become the new stock options.
They were half right. As events have unfolded, it is the unidentical twin of restricted stock—restricted stock units, or RSUs—that has become the most popular alternative to stock options at many companies. You are more likely to receive RSUs than restricted stock.
RSUs share many of the same issues as restricted stock (so the restricted stock sections of this website are worth looking at even if you have RSUs). However, there are differences between the two grant types, and it is important to understand the basics of RSUs in their own right. For additional details on RSUs, you will want to read Part 2 of this article series, which covers RSU taxation, and also the FAQs in the section Restricted Stock Units elsewhere on this website.
A Type Of Full-Value Grant
RSUs are considered a "full-value stock grant" because the grant is worth the "full value" of the shares at the time of vesting. Therefore, unlike stock options, RSUs can never be "underwater" and will always result in some income for you (unless the stock price drops to $0).
Example: Your company grants you 10,000 RSUs. On the vesting date, when the shares are delivered to you, the company's stock price is $22 per share. Thus the grant's value is $220,000 ($22 x 10,000). If the stock price were $17 at vesting, the grant would be worth $170,000. It does not matter what the stock price was on the grant date.
|Shares||Stock price at vesting||Value of shares at vesting (delivery)|
|10,000||$22||$220,000 ($22 x 10,000)|
|10,000||$17||$170,000 ($17 x 10,000)|
RSUs: Restricted Stock Lite?
While restricted stock and RSUs are siblings, they differ in a few important ways that can affect your financial planning. The best starting point is a brief overview of restricted stock and a comparison of the differences.
Restricted stock is a grant of company shares made directly to you. Usually, however, you cannot sell or otherwise transfer the shares until you have satisfied vesting requirements. As long as you continue to work at your company, you will not forfeit your grant, and it will not expire. The principal traits of restricted stock include the following:
- At grant, restrictions on sale and the risk of forfeiture exist until you meet vesting goals of employment length or performance targets, or the vesting accelerates upon the occurrence of a life event (e.g. disability or death) or a corporate event (e.g. a merger or acquisition).
- During the restricted period (i.e. the vesting period), dividends are paid, and grant-holders have voting rights, like shareholders.
Great Taste, But Can Be Less Filling
While the vesting rules are the same with restricted stock units, no stock is actually issued to you when the RSUs are granted—the shares are not outstanding until they are released to you. This is because, technically, RSUs are an unfunded promise to issue a specific number of shares (or a cash payment) at a future time once vesting conditions have been satisfied. In short, until the shares are issued to you at vesting, the grant of RSUs is just a corporate bookkeeping entry. RSUs paid in shares (called stock-settled RSUs) are much more common than cash-settled RSUs, which are subject to troublesome "liability accounting."
Consequently, unlike recipients of restricted stock, holders of RSUs have no shareholder voting rights and do not receive any dividends that the company may pay to its shareholders. However, when a company pays dividends on outstanding shares of stock, it can choose to also pay dividend equivalents on RSUs. These may be deferred or accrued to additional units and then settled when the unit vests and shares are delivered. Alternatively, companies can pay dividend equivalents in cash or wait to pay at vesting by using the money to cover withholding (see the FAQ on dividend equivalents with RSUs).
Alert: You must know four key features of your RSU grants:
Shares Delivered At Vesting
With most restricted stock units, including broad-based grants made under RSU plans at Amazon, Microsoft, and Intel, the delivery of shares occurs at vesting. In effect, this makes RSUs identical to standard time-vested restricted stock, although (as noted above) before vesting the RSUs are just an unfunded bookkeeping entry rather than actually issued shares. Vesting can occur in increments over the course of the vesting period (graded vesting), or all the shares can be delivered at once on a single vesting date (cliff vesting).
For executives, some RSU plans have a tax-deferral feature that lets you select a date for share delivery, or the company specifies one (e.g. retirement). This creates more decisions for you to make, and raises tax complexities that are explained in Part 2 of this article series.
Why Do Many Companies Prefer RSUs Over Restricted Stock?
Until companies started to use restricted stock and RSUs for broad-based grants (often instead of or in combination with stock options), RSUs were mostly used internationally for tax purposes. Now, however, companies widely use RSUs in the United States as well.
For companies, RSUs can be preferable to restricted stock for several reasons that can also be appealing for you. First, because no shares are issued until the time for delivery, the use of a mere bookkeeping entry for the units eliminates administrative costs related to holding shares in custody, proxy voting, and canceling outstanding shares if employment ends before vesting. Second, RSUs eliminate the possibility that you might unwisely choose to make the Section 83(b) election for restricted stock, which is not available for RSUs. Also, depending on the structure of the RSU plan, the company avoids paying cash dividends during the vesting period (see a related FAQ).
These main reasons for using RSUs are augmented by several other benefits:
- Automatic share withholding (or "surrender") for the taxes at vesting can be easier because no shares were issued and there are no transfer-agent records to be changed.
- More specialized RSU plans may let you defer delivery of the shares and thus your ordinary income tax.
- If the grant has a provision that accelerates vesting at retirement, you have no ordinary income when you become eligible to retire but keep working (for details, see a related FAQ).
- RSUs can be easier to use when vesting is performance-based, as no shares need to be issued up front with RSUs. Moreover, the RSUs can be easily canceled if your performance-vesting goal is not met.
- For overseas employees, RSUs prevent hassles in countries where restricted stock is taxed at grant and the taxation may not be delayed until vesting. (See the Global Tax Guide for the tax treatment of RSUs in many different countries.)
Just as RSUs differ in a few significant ways from restricted stock, the taxation of the two is similar but has important distinctions. That is the subject of Part 2 in this article series.