What is a Restricted Stock Unit or RSU?
A restricted stock unit (RSU) is compensation issued by an employer to an employee in the form of company stock. Restricted stock units are issued to an employee through a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with their employer for a particular length of time. RSUs give an employee interest in company stock but they have no tangible value until vesting is complete. The restricted stock units are assigned a fair market value when they vest. Upon vesting, they are considered income, and a portion of the shares is withheld to pay income taxes. The employee receives the remaining shares and can sell them at his or her discretion.
Restricted stock as a form of executive compensation became more popular after accounting scandals in the mid-2000s involving companies like Enron and WorldCom, as a better alternative to stock options. 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. Previously, stock options had been the vehicle of choice, but with scandals, malpractice, and issues of tax-evasion, companies were (as of 2004) able to consider other types of stock awards that might be more effective in attracting and retaining talent. Soon, restricted stock units, which before had typically been reserved for higher levels of management, were being granted to all levels of employees around the world. Accordingly, the median number of stock options granted per company by Fortune 1000 firms declined by 40% between 2003 and 2005, while the median number of restricted stock awards increased by nearly 41% over the same period.
Restricted Stock Unit (RSU)
Advantages of Restricted Stock Units
RSUs give an employee an incentive to stay with a company long term 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 gain minus the value of the shares withheld for income taxes and the amount due in capital gains taxes. Administration costs are minimal for employers as there aren't actual shares to track and record. RSUs also allow a company to defer issuing shares until the vesting schedule is complete, which helps delay the dilution of its shares.
Limitations of Restricted Stock Units
RSUs don't provide dividends, as actual shares are not allocated. However, 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. Restricted stock is included in gross income for tax purposes, and it is recognized on the date when the stocks become transferrable (also known as the vesting date). RSUs aren't eligible for the Internal Revenue Code (IRC) 83(b) Election, which allows an employee to pay tax before vesting, as the Internal Revenue Service (IRS) doesn't consider them tangible property. RSUs don't have voting rights until actual shares get issued to an employee at vesting. If an employee leaves before the conclusion of their vesting schedule, they forfeit the remaining shares to the company. For instance, if John's vesting schedule consists of 5,000 RSUs over two years and he resigns after 12 months, he forfeits 2,500 RSUs.
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 as part of her compensation, in addition to a salary and benefits. The company's stock is worth $10 per share, making the RSUs potentially worth an additional $10,000. To give Madeline an incentive to stay with the company and receive the 1,000 shares, it puts the RSUs on a five-year vesting schedule. After one year of employment, Madeline receives 200 shares; after two years, she receives another 200, and so on until she acquires all 1,000 shares at the end of the vesting period. Depending on how the company's stock performs, Madeline may receive more or less than $10,000.
As a real-world example of what a company does to issue RSUs, take a look at this December 2017 SEC Form 4 filed by the electric vehicle company Tesla, Inc. (NASDAQ: TSLA). This form indicates that Eric Branderiz – the company's former Chief Accounting Officer – who received some restricted stock, wished to convert 4,808 restricted stock units into common shares.
Source: SEC EDGAR