Companies on the IPO track that have historically only awarded stock options tend to become interested in restricted stock units (RSUs) as the IPO date nears. In this article, we shed light on full value awards and how they differ from options. This information is also useful to anyone new to the equity comp industry.
Restricted stock units (RSUs) are a form of stock-based equity compensation. Essentially, a restricted stock unit is an award that gives the recipient the right to receive the value of the number of shares of the underlying company stock at a later date, when the prescribed vesting conditions have been met. Vesting conditions are usually time- or performance-related. There is no purchase or exercise cost associated with restricted stock units and they can be paid out either in stock or in cash, usually at the company’s discretion, but sometimes at the employee’s discretion.
Restricted stock vs. restricted stock unit vs. stock options. What’s the difference?
Restricted stock vs. restricted stock unit
Restricted stock and restricted stock units sound like the same thing but there are essential differences. The main difference is that when restricted stock is granted, the stock is issued at the time of grant, the employee becomes a stockholder and owns the stock, usually subject to vesting conditions (called “reverse vesting” because the stock is already issued), and immediately gains voting rights and can receive dividends.
Restricted stock is commonly granted to founders and executives of privately-held companies to ensure that they have skin in the game for the company’s success, while the reverse-vesting conditions incentivize them to stay with the company while the stock continues to vest. There is often either no purchase price required to receive the restricted stock or the company may credit a founder’s prior investment in the company as the purchase price.
A restricted stock unit is a promise to the employee that they will receive the stock after the vesting conditions have been met. At this time, the restricted stock unit will be settled either in cash or in stock and, if stock-settled, the employee will then be entitled to dividend payments and voting rights.
Restricted stock units are commonly granted by companies that are concerned about limiting shareholder dilution. Since the stock isn’t issued until the award is settled, and even then may be settled in cash instead of stock, restricted stock units have the potential to be less dilutive to existing shareholders than restricted stock. Companies that settle in cash will have to be cashflow positive to meet the payout costs.
The following table is a visual summary of the main differences between restricted stock and restricted stock units.
|Criteria||Restricted stock||Restricted stock unit|
|Actual shares granted||Yes||Promise of stock (or cash) after vesting period|
|Entitled to dividend payments||Yes||Dividend equivalent payments at company discretion|
|Options to make Section 83(b) election||Yes||No|
|Options to deferral election under IRC 409A||No||Yes|
|International tax considerations (dependent on country)||Can be taxed at time of grant instead of vesting||Taxation event at settlement|
Stock options are a different class of equity compensation. Stock options are a promise that an employee will be able to buy stock at a specified grant date price at some time in the future, with the hope that the value of the stock will have risen on that future date.
For example, say an employee was given a stock option when the price of the stock was valued at $50 per share. Two years later, the stock is worth $150 per share. Because of the stock option agreement, the employee would be entitled to purchase the stock for $50 dollars. With the stock option agreement in place, the employee stands to earn a quick $100 per share. *
Like restricted stock and restricted stock units stock options usually have vesting conditions (time- or performance-based) and they also typically include an expiration date.
Restricted stock units, taxes and payout
Restricted stock and restricted stock units are also dissimilar when it comes to handling tax liability payments. *
Restricted stock is taxed under Section 83 of the Internal Revenue Code under what’s known as the “substantial risk of forfeiture” rule. With the exception of death and retirement eligibility concerns, which are beyond the scope of this blog, restricted stock is usually no longer subject to a substantial risk of forfeiture at the time the award vests. Section 83 also allows the restricted stock recipient to file an IRC 83(b) election to accelerate the taxation event to the grant date. An 83(b) election can be useful if the company’s stock is very volatile. For example, if an executive receives a restricted stock award at no cost when the stock price is $10 per share, filing an 83(b) election at grant will freeze the taxable gain at $10 per share. If the executive does not file an 83(b) election, then when the vest date comes, say a year later when the stock price is $50 per share, then the taxable gain at vest will be $50 per share. The vest date taxation event can be especially challenging for private company stockholders when there is no market to sell the shares in order to pay the taxes.
Restricted stock units are taxed under Section 409A of the Internal Revenue Code as deferred compensation. The requirements for issuing awards under Section 409A are very complex. The normal taxation event for restricted stock units is at vesting. Unlike with restricted stock, the employee cannot file an 83(b) election on restricted stock units, but they can file for a deferral of payout after vesting which will also push out the taxation event date.
For both restricted stock and restricted stock units there are several ways for an award recipient to cover their tax liability. Some of the more common methods include the following:
- Issuing a check to the company for the amount of the tax liability
- Payroll withholding to pay taxes from wages due is available in some companies;
- Selling enough shares to cover the amount of the tax liability, usually only available for public company restricted stock awards
- Surrendering enough shares back to the issuing company and the company covers the tax liability, this is often the method for restricted stock awards
- Executing a “net settlement” which reduces the number of shares issued by the number of shares required to cover the tax liability; usually used for settling restricted stock unit awards
Tracking restricted stock units and restricted stock awards
Administering a company’s equity plan can be challenging Restricted stock units can be particularly challenging to manage when you factor in staying on top of vesting periods and the different ways to account for the tax liability payment. It’s way more complex than you’ll ever want to handle in a spreadsheet, and even many equity plan administration platforms available today aren’t fully equipped to do it right.
Luckily, you don’t have to go it alone. Shareworks by Morgan Stanley has thousands of clients who issue restricted stock and restricted stock units, and we’d be happy to put our expertise to work for you. With Shareworks, our equity plan management software, you can say goodbye to high-maintenance processes. Contact us today to find out how Shareworks can help you manage your restricted stock and restricted stock units as well as your stock options, ESPPs and other plan types.
* There are also many differences in the ways that restricted stock, restricted stock units and stock options are taxed. These are important considerations when choosing how to incentivize employees with equity compensation.