What is an RSU Agreement?
In the tech industry, RSU agreements are a common form of employee compensation. In fact, most workers in the tech ecosystem are now hired with a combination of salary, bonus, and equity (or "stock options"). Restricted Stock Units (RSUs) are one way for a company to use equity to reward its employees. All of the major tech companies in Seattle — Amazon, Microsoft, Tableau, and others — provide their employees with RSUs. But most workers in the tech sector, and new hires in fields where RSU agreements are common, know very little about how these agreements work.
An "RSU" is short for "restricted stock unit". Its purpose is to help businesses make their compensation packages more appealing to employees. RSUs are different from stock options, but also serve the same basic purpose: to reward employees by giving them individual ownership in the success of the company. With RSUs, when a worker cashes in on their agreement, the company simply hands over ownership of one or more of its shares. In contrast, with stock options, the company cashes in on behalf of the employee and the employee gets whatever is left over.
Ideally, the company benefits when the employee cashes in, and the employee is rewarded for the company’s success as well. But , with RSUs, there are no out-of-pocket expenses to the employee and no risk that the employee could lose his or her investment in the company. Similarly, there is no reduction of the total number of outstanding ownership interests in the company, because the shares handed over to the employee are not "out of authorized capital", but are instead treasury shares of the company. For this reason, the option to choose either RSUs or stock options may sometimes be represented to the employee as being value-neutral.
However, the value of one type of agreement compared to the other type may not be neutral to the employee. An employee who elects to receive RSUs – as with employee incentive agreements generally – may be giving up the opportunity to make out-of-pocket tax payments up front in exchange for owning property that is either illiquid or of uncertain value at some future time. Is it better for the employee to pay taxes related to the RSUs at vesting, or at the time the RSUs are exercised? If the latter, what is the exercise price to the employee? And what are the tax implications to the employee of exercising the RSUs and holding the shares for taxable gains, over the option to sell the RSUs when they vest, for cash that may be immediately spent?
Elements of An RSU Agreement
Key components of RSU agreements include the award grant date, vesting schedule, distribution terms, and timing. Beginning with the award grant date, it’s important to note that vesting is not immediately automatic. At the time of the RSU’s grant, the holder will not automatically own any specific number of shares of common stock of the company, because (i) there are certain conditions that must be met, such as tenure with the company and/or certain performance milestones, and (ii) the number of actual shares owned by the holder will be increased (or decreased) based on the specific terms of the RSU award agreement and the future performance of the company stock (more on that below). The award grant date becomes a key date, because it is that date that the company puts in writing and agrees to provide the holder with a specific number of common stock shares at a future date subject to the terms and conditions of the award agreement.
The vesting schedule sets out how many shares will eventually be issued to the holder, and when, pursuant to the agreed vesting conditions. For example, vesting may be based on specific employment conditions (i.e., the holder needs to be continually employed by the company on each vesting date) and/or the ongoing performance of the shares (if applicable). In some cases, the company may provide for an early vesting schedule, whereby six months or another set time period preceding a liquidity event (e.g., an initial public offering, merger, sale, etc.) the holder could elect to have an accelerated vesting schedule for all or some of the restricted shares, so that they would be fully vested prior to the liquidity event.
The award agreement may also set out how the payment of shares is intended to occur at the end of vesting. For example, some companies send out checks or deposits for the cash value of the shares, rather than shares themselves. However, many grant agreement documents now provide that all vested shares are meant to be distributed in the form of shares of common stock of the company, rather than cash. If the company is a private company, the award document can provide that the shares must first enter into escrow and be held for a period of time before the holder will be able to freely transfer the shares to the public market or other parties. What’s more, in this type of case (i.e., as opposed to a public company), the company scripts its own stock ownership restriction provisions (whereas a public company is governed by SEC rules and requirements) and so the holder must be mindful of those restrictions and limitations, as they may restrict and/or delay when the shares are obtainable.
Benefits of RSU Agreements
Although there are technical differences between options and restricted stock, the practical advantages of RSUs mimic some of the advantages of options while avoiding many of the disadvantages. In addition to providing a sense of ownership and the possibility to profit from corporate growth, RSUs offer the following benefits for both employees and employers:
- Incentivization. RSUs offer the potential for greater shareholder value. Through stock ownership and its relationship to shareholder value, RSUs provide further incentives to not only those executive officers and senior managers but all employees as well to maximize shareholder value by growing the company’s revenues and increasing profits.
- Reduction of risk of dilution. Unlike options, which have to be repurchased at the exercise price within the ten-year term, an employee does not need to concern herself with the possibility of dilution from a subsequent financing under which shares are sold at a lower valuation than a prior financing from which the employee received options. With RSUs, the employee simply receives the shares without paying consideration.
- No cash outlay required for taxes. Because RSUs are granted without any cash payment, taxes on their value do not have to be paid until the date on which the employee or director sells the shares, or the later of the date six months after the date of grant or on the vesting date. Any tax owing can be paid from the sale proceeds.
- Flexibility. The employer’s ability to control the timing and amount of employee contributions can affect the employer’s ability to deduct the expense on its tax return. The employee has substantially less control over the timing of the income inclusion. However, because of the available deferral of the taxable event with RSUs, the tax treatment can more easily be matched with the flow of cash, and the timing of the deduction can more easily be matched with the timing of the employee’s income inclusion. This flexibility may prompt a more efficient discussion over the timing of the RSU grant and the timing of the vesting rather than with more traded options.
Tax Considerations for RSUs
With RSUs, the only immediate tax liability comes at vesting. When a unit vests, its FMV on that date is treated as ordinary income to the employee and is subject to payroll taxes. Hence, it is suggested that the employee have sufficient cash to pay the taxes on their RSU gain when they vest. The company is required to withhold this amount and remit the taxes to the government. At the same time, the company usually deducts this amount as a business expense.
The amount taxed is the difference between the FMV at vesting and the price paid to acquire the RSU (presumably $0). This means that the employer is not entitled under existing law to take a deduction when the employee sells the shares if the net proceeds are less than the employee’s compensation expense, based on the FMV at vesting. This is a curiously different result than that which can occur in the case of stock options.
For instance, assume that an employer grants RSUs for FMV of $1,000 at the time of grant and there is subsequent fluctuation in FMV at vesting and exercise. The following example illustrates the general rules: This example assumes no dividends or other securities sales by the employee or any other manner of compensation. In this situation, the employer does not receive a tax deduction for the loss associated with the stock price depreciation. Using our example, the employee will have received earn-out equal to the aggregate amount attributable to the shares which vested and sold. However, the employer will not be entitled to treat the loss from the stock’s depreciation as a business deduction, even though the RSU was one of the primary compensatory methods used to retain Sarah and keep her interests aligned with the growth of the company.
RSUs generally do not generate capital gains tax liability. Thus, once RSUs have vested, the income generated from the sale of the RSU shares is not income or loss from a business or trade, but rather capital in nature. However, if at the time of the acquisition of the RSUs, the employee chooses to report the income generated from the vesting event, it becomes employment income and the company maintains a larger tax deduction. If vesting occurs over a multi-year period, it makes sense to spread out the income tax impact as well as the employer’s tax deductions. An example of this is the leave to vest arrangement described in our June 2015 blog on this site.
How RSUs Compare to Other Employee Equity Alternatives
A general comparison of RSUs with other equity compensation alternatives is useful. Like any tool, one form may be better than another in a given circumstance, and so knowing the pros and cons of each can help both employees and employers select the most effective form of compensation.
RSUs vs. Stock Options
Stock options are an earlier version of what are now called "option units," but the two concepts are essentially equivalent. With options, an employee participates more actively in deciding whether and when to convert options to actual shares of stock. Most option plans have exercise periods that range from a minimum of two to three years before an employee can exercise the option until a maximum of approximately ten years. From an employee’s perspective, stock options are more favorable than RSUs because obtaining shares by exercising an option is not a taxable event, whereas, as discussed above, releasing shares from an RSU is a taxable event. From an employer’s perspective, RSUs are often preferable because they provide a hedge against the dilution of the company’s stock. A modest change in a company’s stock price will dramatically affect the decision of whether to exercise stock options, but will not affect the RSU grant. From a company’s perspective , options are usually more favorable: the employee must take the active role in converting the option into shares, but the company does not have to pay the employee anything out of pocket to do so. For RSUs, the tax benefit of the employee’s decision to convert them to shares is at the expense of the company. From a taxation perspective, RSUs are more favorable to the employee because no taxable event occurs when the RSU is granted. From an employer’s perspective, options are preferable because when they know the value of the option(s), they can take the appropriate deductions.
RSUs vs. ESPPs
RSUs and employee stock purchase plans (ESPPs) are similar in that they both typically involve transferring shares of stock from the company to the employee. However, obtaining stock under an ESPP is usually a taxable event because the grant of the right to buy employee stock is often considered a property interest that is vested once granted. Like ordinary stock options, employees are usually taxed on the bargain element (i.e., the difference between the market price and the pre-set price) at the time they sell the shares, and they often re-allocate employment tax withholdings to the company. However, there are many variables involved in ESPP plans, and if you are interested in a deeper comparison between RSUs and ESPPs, please stay tuned for our upcoming article on this topic.
Common Mistakes In RSU Agreements
One common pitfall in RSU agreements is for the employer to attempt to sneak in vesting schedules that are not in the best interest of the employees or put unnecessary limitations on the rights associated with the granted equity. Not infrequently, our firm has seen vesting schedules of this sort in RSU agreements: (i) requiring one hundred percent (100%) of the earned vested shares to be held for an additional year after the normal vesting date, and/or (ii) requiring a yearly increase in the number of earned shares to be held for an additional year after the normal vesting date (i.e. the year one hundred (100%) of the earned shares are required to be held). One common reason for these vesting provisions is to avoid issuing whole shares, as the employers would rather hold any fractional shares until the next vesting date, when a whole number of shares will be available to issue; however, there are other ways to avoid issuing fractional shares without the instances mentioned herein. As a general rule, the Controlled Corporation must be cautious of what it puts in its RSU agreements, that being said, most are enforceable as typically the employer holds the right to amend or terminate the agreements.
A second common pitfall in RSU agreements involves taxes. In addition to normal tax implications, RSUs are subject to another level of taxation: FICA (Federal Insurance Contributions Act). Consequently, expect to see tax withholding at the time of vesting in RSUs agreements, as the employer must collect this tax from the employee at this time. That being said, the employer must make sure that the designation of the payment to the employee is correct and clear, as an incorrect designation may have serious consequences to the Controlled Corporation. Further, to reiterate, the Controlled Corporation should be aware of the tax implications of these agreements.
Also, employers should be careful when stating tax implications in their RSU agreements. In a recent case out of the United States District Court for the Southern District of Illinois, the District Court determined that the Defendant was not required to indemnify the Plaintiff for taxes resulting from the vesting of Restricted Stock Units, as the RSU agreement clearly stated that the Company "shall not be liable for tax penalties except as may be required under Federal law," and the District Court found that the tax penalties at issue in the case were triggered by the Plaintiff’s own delay in filing his tax returns.
Negotiating an RSU Agreement
Employees facing a restricted stock unit ("RSU") grant have a much greater ability to negotiate an RSU agreement than they do to negotiate other benefits such as cash compensation, health insurance coverage, and even equity grants. An employee’s prior performance, future potential, long term value to a company, vested interests in cash compensation, and general market conditions all weigh heavily in the balance during any negotiations for an employment opportunity, but the negotiation of an RSU grant is primarily focused on the compensation package that the RSU grant represents.
The most important factor when negotiating an RSU award is being able to project an expected value for the grant, so that the employee knows what he or she is getting. RSU grants are, in general, a component of an equity compensation plan, where employees are granted the opportunity to purchase shares of restricted stock or to receive shares of stock as a result of the vesting of RSUs at or just below market value. The long term benefit to an RSU grant, therefore, is the ability of the RSU recipient to purchase or receive shares of stock at what is expected to be or become a substantially lower price than the price at which the stock would trade on an open market. One word of caution: The anticipated cost of exercising an RSU will be based on the underlying equity value of the company, which may vary significantly depending on the outcomes of various scenarios. There are many potential structural features that can be offered by an employer that will influence the calculation of the expected outcome (i.e . , whether the employee expects to exercise an RSU award or just let the award expire) and the best structure for the expected outcome.
For example, in the event of a merger, if the acquirer requests that the employee exchange the RSUs for awards of the acquirer that provide for vesting over a longer period of time, then the employee may have to choose between accepting a purchase price that is significantly lower than the expected market price of the shares of the acquirer that will be delivered in the substitution.
However, if the employee does not value the new award highly, i.e., the new award does not have very favorable terms or is expected to have a much lower stock price than that of the existing company, that RSU could be left to lapse. Similarly, if the acquirer is an investment company with no current plans to become a public company, the employee will simply be foregoing the RSU or the underlying shares in order to get something that could never pay out to him or her.
If an employee cannot expect to purchase an RSU at a preferred price, then the RSU is nothing more than a bonus deferred until the employee resigns or the employer believes the employee has earned the bonus for the RSU. An RSU that is "already earned" is much less valuable than an RSU that has not been issued. In those situations, almost all of the high value of the RSU grant is associated with the bonus effect of the RSU grant, rather than its real investment value. Employees facing a decision on RSU grants should focus on the value of the RSU, the cash compensation in the market, outstanding balance options, and whether the RSU fits within an overall plan to achieve a particular personal goal such as motherhood, retirement, etc.
