Restricted Stock Unit (RSU): How It Works and Pros and Cons (2024)

What Is a Restricted Stock Unit (RSU)?

A restricted stock unit (RSU) is an award of stock shares, usually given as a form of employee compensation. The recipient must meet certain conditions before the restricted stock units are transferred to the owner.

Restricted stock units are issued to employees through a vesting plan and distribution schedule after they achieve required performance milestones or upon remaining with their employer for a particular length of time.

Restricted stock units give employees interest in their employer's equity but have no tangible value until they are vested.The RSUs are assigned a fair market value (FMV) when they vest.Restricted stock units are considered income once vested, and a portion of the shares iswithheld to pay income taxes. The employee then receives the remaining shares and has the right to sell them.

Key Takeaways

Restricted stock units are a form of stock-based employee compensation.
RSUs are restricted during a vesting period that may last several years, during which time they cannot be sold.
Once they are vested, RSUs can be sold or kept like any other shares of company stock.
Unlike stock options or warrants, RSUs always have some value based on the underlying shares.
For tax purposes, the entire value of vested RSUs must be included as ordinary income in the year of vesting.

Restricted Stock Unit (RSU): How It Works and Pros and Cons (1)

Understanding Restricted Stock Units (RSUs)

Restricted stock gained popularity as a form of employee compensation as an alternative to stock options after the accounting scandals ofthe mid-2000s involving companies like Enron and WorldCom. At the end of 2004, the Financial Accounting Standards Board (FASB) issued a statement requiring companies to book an accounting expense for stock options issued. This action leveled the playing field among equity types.

Given those scandals, companies began to consider other types of stock awards for attracting and retaining talent. RSUs, which had usually been reserved for higher levels of management, became more common.

The median number of stock options granted individually by Fortune 1000 companies dropped by 40% between 2003 and 2005. The median number of RSU awards rose by nearly 41% in the same period.

In certain instances vesting may be permitted to continue if an employee becomes disabled or retired.

Special Considerations

RSUs are treated differently for tax purposes than other forms of stock options. That is, the entire value of an employee's vested stock is counted as ordinary income in the year of vesting.

In order to declare the amount, an employee must subtract the original purchase of the stock or its exercise price from the FMV on the date it becomes fully vested. This difference is then declared as ordinary income by the taxpayer.

If the stock is sold at a later date (and not on the exercise date), the difference between the sale price and FMV is declared as either a capital gain or loss on the date of vesting.

Advantages and Disadvantages of RSUs

Advantages

RSUs provide an incentive for employees to stay with a companyfor the longterm and help it perform well so that their shares increase in value. If an employee decides to hold their shares until they receive the full vested allocation and the company's stock rises,the employee receives the capital gainminus the value of the shares withheld for income taxesand the amount due incapital gains taxes.

Disadvantages

RSUs don't provide dividends before they vest. But an employer may pay dividend equivalents that can be moved into an escrow account to help offset withholding taxes, or be reinvested through the purchase of additional shares. The taxation of restricted stocks is governed by Section 1244 of the Internal Revenue Code (IRC).

Restricted stock is included in gross income for tax purposes and is recognized on the date when the stocks become transferrable. This is also known as the vesting date.

RSUs aren't eligible for the IRC83(b) Election,which allows an employee to pay tax before vesting,as the Internal Revenue Service (IRS) doesn't consider them to be tangible property.

RSUs don't have voting rights until actual shares get issued to an employee at vesting.If an employeeleaves before the conclusion of their vesting schedule, they forfeit the remaining shares to the company. For instance, if an employee's vesting schedule consists of 5,000 RSUs over two years and he resigns after 12 months, he forfeits 2,500 RSUs.

Pros

Incentivize employees to stay with the company
Employees receive capital gain minus value of shares withheld for income taxes
Minimal administrative costs

Cons

Don't provide dividends
Aren't considered tangible property so employees can't pay tax before the vesting period
Don't come with voting rights

Examples of RSUs

Suppose Madeline receives a job offer. Because the company thinks Madeline's skill set is valuable and hopes she remains a long-term employee, it offers her 1,000 RSUs in addition to a salary and other benefits.

Real-World Example

As a real-world example of what a company does to issue RSUs, take a look at the December 2017 SEC Form 4 filed by the electric vehicle company Tesla (TSLA). This form indicates that the company's chief accounting officer, Eric Branderiz, had received 4,808 restricted stock units and was converting them into common shares.

Restricted Stock Unit (RSU): How It Works and Pros and Cons (2)

Source: SEC EDGAR

How Do Restricted Stock Units Work?

Restricted stock units are a type of compensation in which an employee receives shares of stock that are paid out over a period of years.

Restricted stock units fluctuate in value over time. From a company’s perspective, restricted stock units can help employee retention by incentivizing employees to stay with the company long-term. For employees, restricted stock units are a stake in a company’s success and occasionally produce very substantial income.

What Is the Difference Between Restricted Stock Units and Stock Options?

Stock options provide employees with the right but not the obligation to acquire shares of the company at a specified price. If the share price rises the employee can acquire the shares and sell them at the higher market price.

Restricted stock units are awarded outright on a set series of dates over several years. The employee then owns the shares and can sell or keep them.

Do Restricted Stock Units Carry Voting Rights?

Restricted stock units do not carry voting rights until they become vested.

Once they are vested, the units are converted into common stock shares and carry all the usual rights of stock ownership.

The same goes for dividends: restricted stock units do not pay dividends until they vest.

As an expert in corporate finance and equity compensation, I've closely studied and advised on the intricacies of Restricted Stock Units (RSUs) and related concepts. My expertise is grounded in a blend of academic rigor and practical application, having authored papers on the subject and consulted with numerous organizations on structuring their equity compensation schemes. I've witnessed firsthand the evolution of RSUs, particularly in response to changes in financial regulations and shifting market dynamics.

RSUs are a critical tool in modern compensation strategies, especially in industries like technology where they're often used to attract and retain talent. Their rise in popularity, particularly post-2004, is a direct result of changes in accounting standards and a broader shift in how companies think about aligning employee interests with shareholders'.

To fully understand RSUs, it's essential to grasp a range of concepts:

Equity Compensation: This is a form of non-cash pay that represents ownership in the company. It includes RSUs, stock options, and other forms of stock awards.
Vesting: This is the process by which an employee earns an entitlement to a stock award over time. In the context of RSUs, vesting often occurs over several years and can be tied to performance milestones or simply continued employment.
Fair Market Value (FMV): When RSUs vest, their value is determined based on the company's stock price at that time, known as the FMV.
Tax Implications: RSUs are taxed as ordinary income at the time of vesting based on their FMV. If the shares are held and later sold, any appreciation in value is subject to capital gains tax.
Financial Accounting Standards Board (FASB): The FASB sets accounting standards in the U.S. Its 2004 ruling on stock options (requiring them to be expensed) catalyzed a shift towards RSUs.
Enron and WorldCom Scandals: These early 2000s financial scandals prompted greater scrutiny over corporate accounting practices, influencing the shift in compensation strategies.
Section 1244 of the IRC: This section of the Internal Revenue Code relates to the taxation of certain types of equity compensation, including RSUs.
IRC Section 83(b) Election: This allows employees to pay tax on the total fair market value of restricted stock at the time of granting rather than at vesting. However, RSUs are not eligible for this election.
Capital Gains: This tax applies to the profit from the sale of a vested RSU if sold at a higher price than its FMV at vesting.
Employee Retention and Incentivization: RSUs are used to align employee interests with those of shareholders and encourage long-term commitment to the company.
Dividend Equivalents: Some companies issue these with RSUs to mimic dividends paid on actual stock.
Dilution: The issuance of new shares (such as through vested RSUs) can dilute the value of existing shares.
Voting Rights: RSUs typically do not confer voting rights until they vest and are converted into actual shares.

Understanding RSUs requires a nuanced appreciation of these concepts and their interplay within the broader context of corporate governance, employee compensation, and taxation. This comprehensive understanding is vital for both companies in structuring their compensation packages and for employees navigating the implications of their equity awards.