What Are Restricted Stock Units (RSUs)?
Understand Restricted Stock Units (RSUs), a key form of equity compensation. Learn how they work, from vesting to taxation.
Companies often provide various forms of compensation beyond a regular salary to attract and retain skilled employees. Restricted Stock Units (RSUs) are a prevalent type of equity compensation, offering employees a stake in the company’s future success. These awards align employee interests with shareholder value, incentivizing long-term commitment and performance, and can significantly contribute to an employee’s overall financial well-being.
What are Restricted Stock Units?
A Restricted Stock Unit (RSU) is a commitment from an employer to grant company stock shares to an employee at a future date, provided certain conditions are met. Unlike traditional stock, RSUs do not confer actual ownership on the grant date; they are a promise to receive shares once specified restrictions are satisfied.
The “restricted” aspect signifies that share distribution is contingent upon a vesting schedule. Until RSUs vest, they do not represent actual stock ownership.
The process begins when an employee is “granted” RSUs, meaning the company allocates a number of units corresponding to its stock. This grant outlines the terms and conditions for units to convert into actual shares. Once these conditions are met, the shares are “delivered” to the employee, becoming transferable and tradable.
Employees do not purchase the stock; it is awarded once vesting criteria are satisfied. The value of RSUs is tied directly to the company’s stock price, incentivizing employees to contribute to company growth.
The Vesting Process
The vesting process transforms the initial promise of shares into actual ownership. It dictates when and how an employee gains full rights to granted RSUs.
Vesting schedules can vary significantly from one company to another. A common type is time-based vesting, where a percentage of RSUs become available at regular intervals over a set period, such as 25% each year over four years. Another form is cliff vesting, which involves an initial waiting period, often one year, before any RSUs vest, followed by a lump sum or gradual vesting thereafter.
Beyond time-based conditions, some RSUs may have performance-based vesting, requiring the achievement of specific company or individual goals. These performance targets could include reaching certain financial milestones, such as revenue targets or an initial public offering (IPO). Some RSUs, particularly in private companies, feature “double-trigger” vesting, which requires both a time-based condition and a specific company event, like an acquisition or IPO, to be met.
The vesting date is the point when the RSU holder gains full ownership of the shares. If an employee leaves the company before their RSUs vest, they forfeit any unvested units. This provision encourages employee retention and long-term commitment.
Taxation Basics of RSUs
Understanding the tax implications of Restricted Stock Units is important for employees. Unlike other equity awards, RSUs are not taxed at grant. The tax event primarily occurs when RSUs vest.
When RSUs vest, the fair market value (FMV) of the shares on the vesting date is considered ordinary income. This amount is added to the employee’s taxable income and is subject to federal income tax. Employers typically withhold a portion of vested shares or their cash equivalent to cover these obligations. Income from RSUs is reported on the employee’s Form W-2 for the vesting year.
A second tax event occurs if the employee sells the vested shares later. Any gain or loss from the sale, calculated as the difference between the sale price and the FMV at vesting (which serves as the cost basis), is treated as a capital gain or loss. If shares are held for one year or less after vesting before being sold, profit is a short-term capital gain taxed at ordinary income rates. If held for more than one year, gain qualifies as a long-term capital gain, taxed at lower rates.
RSU vs. Other Equity Awards
Restricted Stock Units are one of several ways companies provide equity compensation. Understanding how RSUs differ from other common equity awards, such as Restricted Stock and Stock Options, clarifies their unique characteristics.
Restricted Stock (also known as Restricted Stock Awards or RSAs) differs from RSUs because the employee receives actual shares at grant. Though owned from the grant date, these shares are subject to forfeiture until vesting conditions are met. In contrast, with RSUs, the employee only receives a promise of shares and does not become a shareholder until units vest and shares are delivered.
Stock Options grant an employee the right to purchase a specified number of shares at a predetermined price (the “strike price”). Employees must pay to exercise these options, and their value depends on the stock price exceeding the strike price. RSUs do not require payment; they are simply granted upon vesting. Unlike stock options, which can become worthless if the market price falls below the strike price, RSUs always retain value as long as the company’s stock has value above zero.