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There are many forms of equity- or stock-based benefits that an employee can receive as part of their compensation package. One that’s common is restricted stock units. RSUs, along with other forms of equity compensation, can be complex and require detailed planning for employees to reap the greatest reward.
What are restricted stock units, or RSUs?
RSUs are a type of equity compensation that grants employees a specific number of company shares subject to a vesting schedule and potentially other stipulations. The vesting schedule dictates when ownership rights are activated, typically upon completing a certain number of service years.
Companies use RSUs as an incentive to attract and retain talent. RSUs are appealing because if the company performs well and the share price takes off, employees can receive a significant financial benefit. This can motivate employees to take ownership. Since employees need to satisfy vesting requirements, RSUs encourage them to stay for the long term and can improve retention.
Types of RSUs
Employers can offer RSUs with different restrictions. Some are subject to only a vesting schedule and may be referred to as single-trigger RSUs. Others may include additional conditions that must be fulfilled along with vesting; these are called double-trigger RSUs.
Single-trigger RSUs: time-based vesting
Here’s an example. Say you’ve been granted 1,500 RSUs and the vesting schedule is 20% after one year of service, and then equal quarterly installments thereafter for the next three years. This would mean that after staying with your company for a year, 300 shares would vest and become yours. For the next three years, every quarter that you remain employed by the company, you’d receive ownership of another 100 shares.
The above example illustrates a graded vesting schedule, with periodic grants vesting over the course of a few years. Employers can also use cliff vesting, where all grants vest together at once. For instance, all 1,500 shares vesting after three years.
Until the vesting date is reached, your grants have no value.
Double-trigger RSUs: performance-based goals
RSUs can have other restrictions beyond a vesting schedule that are often related to performance. This can mean that the company needs to reach certain milestones — such as a product or service launch — or undergo a liquidity event like a merger, acquisition, or becoming public through an initial public offering, direct listing, or SPAC listing.
Tax liability of RSUs
When RSUs are granted to you, shares don’t become rightfully yours until you meet the vesting requirements and any other conditions. At this point, you’ll have no tax consequences because you don’t technically own the shares yet. However, once your shares vest, this triggers a tax liability.
The value of your vested shares equals the number of shares times the fair market value of the shares. This value is taxable as income to you, and your company will need to withhold the required taxes.
Some companies may offer you the ability to offset your tax liability by reducing the shares received by the amount of tax owed. For example, if you have 300 shares vest and they’re worth $10 a share, you’ll need to pay tax on income of $3,000. Assuming a 30% tax bracket, your tax bill will be $900, or 90 shares. You may be able to elect to receive only 210 shares, using 90 shares to cover your tax bill.
Other companies may not provide this perk, which means the employee must pony up cash to cover taxes upon vesting.
Selling vested shares
Whether you can sell your shares to generate cash depends on if your employer is a public or private entity.
Public company: If your employer is a publicly traded entity, its shares trade on a stock exchange and will usually have decent trading volume. This means that you can sell your shares at any time, so long as you are satisfied with the share price. Employees needing cash to pay for taxes have the option to sell shares upon vesting for this purpose.
Some employees may want to hold on to their shares out of company loyalty or because they believe in the company’s future prospects. However, having too much exposure to one company or stock can result in a concentrated stock position, which can increase the risk of your portfolio. You may choose to sell shares and produce cash to fund other financial goals.
Selling shares can also have tax consequences if the sale results in a capital gain. Holding shares for over a year before selling qualifies as a long-term capital gain, which is generally subject to less tax than a short-term capital gain.
» Concerned about capital gains? Discover strategies to reduce capital gains tax
Private company: If your employer is a nonpublic entity, your shares can’t be easily sold since there is no readily available marketplace. This means that employees may need to fund taxes out of pocket, and explains why some companies issue double-trigger RSUs with a liquidity event provision — when a liquidity event occurs, it offers an opportunity to sell shares. Employees can use that sale to fund the tax liability.
With limited options for selling shares, you’ll likely need to sit tight and hope for your company to have a liquidity event. Note that some liquidity events, such as an IPO or SPAC listing, have lock-up periods, which means you won’t be able to sell your shares right away.
Even though you may need to wait for an exit opportunity to appear, the future benefit may be worth the wait if your company is on an accelerating growth trajectory and the value of your shares rises over time. If you’re confident that your company’s shares will be worth more once it becomes public and you have enough cash to cover the taxes, you may want to consider holding on to every last share and paying taxes out of pocket in hopes of a larger payoff down the road.
Benefits of RSUs
Simplicity. Compared to other forms of equity compensation such as stock options, RSUs are easier to understand. The vesting schedule lays out when you’ll receive shares and calculating the value of your award is clear-cut.
No purchase necessary. With stock options, employees have the right to purchase shares of company stock at a certain price, called the strike or exercise price. With RSUs, the shares become yours upon vesting; there’s no purchase necessary. Since some companies allow you to surrender shares to cover your tax withholding, RSUs typically cost less than stock options for the employee.
Retains value. Unless the share price of your company goes to $0, RSUs will still have value, whereas stock options might not. With stock options, when the strike price is lower than the market price, you could exercise your options — buy shares at the lower strike price, sell at the higher market price and profit from the difference. However, if the strike price stays above the market price, there’d be no reason to exercise your options; you could buy shares through the stock exchange for less. That means your options could expire worthless. With RSUs, if 300 shares vest at $10 a share, selling yields $3,000. Even if the share price drops to $5 a share, you could still make $1,500.
Flexibility. Once shares vest, they are yours to keep, even if you leave the company. RSUs provide employees with flexibility, particularly if the company is publicly traded. Employees can sell vested shares to fund other priorities — using the cash to contribute toward retirement accounts, pay off debt, fund a house down payment or contribute to a child’s college savings account.
Drawbacks of RSUs
Tax consequences. If your company isn’t public and is unable to assist with offsetting your tax burden, finding the cash to afford taxes could be difficult for some employees. For those with a large number of double-trigger RSUs, you could face a hefty tax burden once a liquidity event occurs and all your shares vest at one time.
Even if your employer assists with managing the taxes, the amount of shares surrendered or cash payment withheld for taxes may not completely offset the actual tax owed. Employees could be hit with additional tax consequences when it comes to tax filing time, depending on their tax situation.
» Looking for ways to reduce taxes? Consider charitable giving and other tax strategies
Uncertain future. With private companies, you’ll be subject to an uncertain waiting period before being able to sell and receive any reward for fronting those taxes. Though the eventual award can be compelling, it can also disappoint if the company does not grow as planned.
It can make sense to consult with a financial or tax advisor to formulate your plan of action, taking into consideration your personal financial circumstances when designing your strategy for holding or selling.