How Do Your Restricted Stock Units Work?

Restricted Stock Units (RSUs) are a form of equity compensation where an employer promises to deliver company stock to an employee at a future date. This delivery is contingent upon specific conditions, typically continued employment or performance metrics. RSUs align employee financial interests with company success, encouraging contributions to growth and profitability. They also serve as a retention tool, as the full value is realized only after a specified service period.

Understanding Restricted Stock Units

Restricted Stock Units (RSUs) are a type of compensation where an employer promises to issue company shares at a future date. RSUs are not actual shares when granted; they are a contractual right to receive shares later. This “restricted” nature means units are subject to forfeiture until vesting conditions are met.

The value of an RSU derives directly from the underlying company stock. Unlike stock options, which give an employee the right to purchase shares at a set price, RSUs have inherent value as long as the stock price is above zero, making them less risky for employees. Companies use RSUs to attract and retain talent, offering a direct stake in future success and boosting compensation without requiring upfront employee investment.

Before vesting, RSUs are “phantom stock” or “book-entry” shares, existing as a future obligation on company books. Employees do not hold voting rights or receive dividends until conversion to actual shares. This structure incentivizes employees with equity without immediate dilution or cash outflows until vesting conditions are satisfied.

The Grant Process

The award of Restricted Stock Units typically begins with a formal grant, often as part of an employee’s compensation or a performance bonus. The company communicates the RSU award terms through a grant agreement.

This grant agreement is a legally binding document outlining all terms and conditions governing the RSU award. It details the total number of RSUs granted, the specific grant date, the vesting schedule, and any performance conditions. No actual shares are transferred on the grant date.

The grant agreement serves as the foundational document for the RSU award, providing clarity on the employee’s future entitlement to company stock. Employees should review this agreement to understand their obligations and the conditions required for the RSUs to eventually vest.

Vesting Conditions and Schedule

Vesting is the process by which an employee gains full ownership of Restricted Stock Units, transforming them into actual company shares. This involves satisfying specific conditions outlined in the grant agreement. Until vesting occurs, RSUs remain restricted and subject to forfeiture.

Two primary types of vesting conditions are commonly employed. Time-based vesting is most prevalent, requiring the employee to remain employed for a specified duration. Common schedules include “cliff vesting,” where a portion vests after a set period (e.g., 25% after one year), followed by graded vesting, where remaining shares vest incrementally (e.g., monthly or quarterly over subsequent years).

Performance-based vesting ties RSU vesting to specific company or individual performance metrics, such as revenue targets or product development milestones. If these conditions are not met, unvested RSUs may be forfeited. The vesting schedule dictates when restrictions are lifted and the employee acquires ownership of the shares.

What Happens at Vesting

On the scheduled vesting date, Restricted Stock Units convert into actual company shares, which are then released to the employee. The fair market value (FMV) of these vested shares on the vesting date becomes taxable income to the employee.

This value is considered ordinary income and is subject to federal, state, local, and payroll taxes (FICA). To cover these immediate tax obligations, companies typically employ a “sell-to-cover” or “net share settlement” mechanism. Under this method, a portion of the newly vested shares is automatically sold to generate the cash needed to remit the required taxes.

The remaining shares, after tax withholding, are deposited into the employee’s designated brokerage account. For instance, if an employee vests 100 shares at $50 per share with a 30% tax rate, 30 shares would be sold to cover the $1,500 tax liability, and the employee would receive 70 shares. This process ensures tax obligations are met without requiring personal funds.

Managing Vested Shares

Once Restricted Stock Units have vested and shares are deposited into an employee’s brokerage account, the employee gains full control. The shares are no longer restricted and can be managed like any other publicly traded security. Employees generally have two main choices: holding them or selling them.

Choosing to hold shares means the employee retains ownership, allowing for potential appreciation in the company’s stock price. However, holding shares also exposes the employee to the risk of potential declines in value. If held shares are later sold at a price higher than their fair market value on the vesting date, the difference is a capital gain, subject to capital gains tax. Selling for less results in a capital loss.

Alternatively, an employee can sell some or all vested shares immediately or later. Selling shares provides immediate liquidity, converting equity into cash. Any gain or loss is calculated based on the difference between the sale price and the fair market value on the vesting date. Employees should consider diversification, as concentrating wealth in employer stock can concentrate risk. Company-imposed blackout periods may also influence sale timing.