What is a Restricted Stock Unit (RSU)?
A Restricted Stock Unit (RSU) represents an form of granting shares often used as compensation for employees. The actual receipt of these shares by the employee is subject to compliance with certain pre-established conditions.
Companies issue RSUs to their employees following a vesting plan, that is, a schedule that establishes when the shares become the property of the employee, usually after reaching certain performance objectives or remaining with the organization for a specific period.
RSUs give the employee an interest in the company's equity, but they have no real value until they fully vest. These units are assigned a fair market value (FMV) at the time of acquisition. Considered income at the time they are acquired, a fraction of the shares are often withheld for tax payments. Subsequently, the employee receives the remaining shares and can choose to sell them.
How Restricted Stock Units (RSUs) Work
RSUs became a popular alternative to stock options as a form of compensation following the financial scandals of the 2000s with companies like Enron and WorldCom. In response, in 2004, the Financial Accounting Standards Board (FASB) required companies to record accounting expenses for stock options issued, thus leveling the playing field between different types of shares.
In light of these scandals, organizations began to adopt other types of stock compensation to attract and retain talent. RSUs, once more common at executive levels, have become more widely offered.
Between 2003 and 2005, there was a 40% drop in the average number of stock options granted by Fortune 1000 companies, while the number of RSUs increased by almost 41% over the same period.
Special Considerations
RSUs have different tax treatment than other forms of stock options. The total value of the shares when acquired is recorded as ordinary income in the year of acquisition by the employee.
To report this value, the employee must calculate the difference between the share's initial acquisition cost or its exercise price and the FMV on the date the acquisition is completed. This difference is then treated as ordinary income.
If the shares are sold later, any gain or loss, calculated from the difference between the sale price and the FMV on the acquisition date, is considered a capital gain or loss.
Pros and Cons of RSUs
Pros
- Employee Retention Incentive: RSUs encourage employees to remain tied to the company, increasing talent retention.
- Capital Gain: Employees can profit from the capital gain from shares, deducting the amount withheld for tax payments.
- Low Administrative Costs: The process of managing RSUs involves reduced administrative costs for the company.
Cons
- No Dividends: RSUs do not offer dividends to holders.
- Non-Tangible Assets: Prior to the vesting period, employees cannot use RSUs for tax payments as they are not considered tangible assets.
- Lack of Voting Rights: RSUs do not confer voting rights until they are fully vested.
Examples of RSUs
Suppose Madeline receives a job offer from a company that highly values her skills and wants her to stay for many years. As part of the offer, Madeline receives 1.000 RSUs in addition to her salary and other benefits.
Each share of the company is valued at $10, which gives the RSUs a potential value of $10.000. To motivate Madeline to stay with the company, RSUs are distributed according to a five-year vesting plan.
Madeline acquires 200 shares after her first year, and the same number in subsequent years until she completes the acquisition of 1.000 shares. The final amount Madeline receives will depend on the performance of the company's shares during that period.
Conclusion
Restricted Stock Units (RSUs) are an effective compensatory tool that companies use to attract and retain valuable talent. Although they do not offer immediate dividend or voting rights, they provide an opportunity for significant financial gain based on the company's success and growth. The vesting structure of RSUs motivates employees to remain committed to the company over the long term, while aligning employee interests with corporate objectives.
On the other hand, RSUs also have disadvantages, such as the lack of immediate liquidity and tangible benefits until vesting conditions are met. Despite this, the retention advantages and appreciation potential make RSUs an attractive option for both employers and employees.
FAQ
How do restricted stock units work?
RSUs are a form of compensation where shares are granted to the employee and paid out over a stipulated period. The value of RSUs may vary over time. For the company, they are a tool to retain talent by encouraging long-term retention. For employees, they represent a bet on the company's future success and can result in significant financial benefits.
What is the difference between restricted stock units and stock options?
Stock options give an employee the right, but not the obligation, to purchase company stock at a predetermined price. If the value of the shares increases, the employee can purchase them at a lower cost and sell them at a higher price. On the other hand, RSUs are granted and vest on specific dates over several years, after which the employee can sell or keep them.
Do restricted stock units have voting rights?
No, RSUs do not have voting rights until they fully vest. After acquisition, they are converted into common shares, providing all the typical rights of a shareholder, including voting rights.
Do RSUs pay dividends?
RSUs do not generate dividends until they are vested and converted into common stock.
