A restricted stock unit (RSU) is an effective way to motivate employees. It is also an excellent option for employees on their career path as they build an investment portfolio. In this article, I’m going to outline exactly what an RSU is, how it works, and what the advantages and disadvantages of this type of stock are.
What is a Restricted Stock Unit?
RSUs are used by employers to compensate employees for reaching an employment milestone. This could be for being with a business for an agreed amount of time or for having performed duties above and beyond expectations.
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It’s important to know that restricted stock units operate differently to normal or common stock in several ways.
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How do Restricted Stock Units Work?
RSUs are issued based on contract stipulations. When an employee joins a company or signs a new contract, that contract will outline any rewards or bonuses owed to the employee. Usually, such bonuses are given in the form of cash, non-financial incentives, or shares. RSUs fall into the latter category, but they work in a similar way.
When the contract is initially assigned, the value of each share is given a fair market value. That is, the share value is in the ballpark of what investors would normally pay at that time.
Once an employee has reached the agreed performance or duration of employment milestone, RSUs are issued to them. This is achieved through a vesting plan.
A vesting plan outlines the exact number of RSUs and the factors allowing for their provision. This also stipulates when the vesting schedule will be completed and all remaining RSUs will be issued.
Many vesting plans state that an employee will be issued a portion of agreed shares at intervals. For example, a five-year vesting plan of 500 shares, could be broken down into 100 shares awarded per year of service.
A critical distinction from common shares is that only once the vesting period is complete, do the shares become tangible assets. In other words, while an employee might theoretically own 100 shares for a year’s service, they only actually receive the real-world shares when the vesting schedule has finished.
When RSUs vest and become tangible assets, a company will issue either real shares or pay its market value to the employee. When they become real shares, they are usually common stock.
The RSUs may have subsequent stipulations attached to them even after they vest, such as a holding period where the employee must not sell the shares within a defined time period, often one to two years. Once this period is over, the employee may sell the shares like any shareholder and profit from that sale.
How to Treat Restricted Stock Units
It’s important at this point to realize that RSUs are a legal and financial form of compensation. They cannot be handed over as if they do not have financial value. Furthermore, when received, RSUs are legally seen as income.
This means that they must be taxed. As your employer may process tax for you, they will also have to process the taxed restricted shares when they are issued. To do this, an amount of the shares equal to the value of the tax owed is withheld from the employee.
Restricted Stock Units and Executive Compensation
If you are an executive or board member, you may be entitled to RSUs as part of your contractual agreement with the business. Again, this may be due to how many years you have served with the company or for reaching performance thresholds.
Performance milestones are slightly different for executives as they are usually intertwined with the performance of the overall business or department they oversee. As executives have much more input in guiding a company, their payouts are linked to business development and this is a crucial part of the vesting depending on milestones associated with stock options.
Employees, on the other hand, are usually only measured on their personal performance, which may or may not actively affect business health.
Interestingly, in the past RSUs were primarily handed out to executives and not general employees. However, in 2004, after a series of scandals that rocked the financial world, the Financial Accounting Standards Board (FASB) legislated that companies had to tie stock options into their expenses.
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This meant that executives could no longer essentially be given a free payout through stock options. Instead, RSUs became more popular as a way to reward executives and other employees alike.
Advantages of Restricted Stock Units
One of the great things about RSUs is that they incentivize performance and loyalty. Because employees are aware that if they reach a specific length of employment that they will receive RSUs, they are more likely to stay with a business. They also feel part of something.
Likewise, when employees improve their performance and aim for a set performance milestone, they positively impact those around them while earning their RSU payment. With each milestone payment, there is the desire to perform well and meet the next one.
Because RSUs are essentially non-functioning until the stipulated vesting period is complete, employees have a reason to stay until the end of that duration. This also means that a business does not technically need to dilute their shares when RSUs are first issued, only having to do so at the end of a vesting plan.
Disadvantages of Restricted Stock Units
It can be frustrating to own RSUs, knowing that technically you own shares, but you can’t sell them or receive dividends until the end of the vesting schedule.
Despite not earning revenue like common stock, RSUs are still taxed. This tax is part of an individual’s gross income, and therefore increases the amount of tax required. However, companies can offset these tax payments for employees by paying equivalent dividends into an escrow account.
RSUs also have the disadvantage of no associated voting rights. Until the vesting period is complete and the real shares are issued, the RSUs are essentially glorified IOUs. This means that although an employee owns the promise of stock, they don’t yet have it. Therefore, they receive no voting rights like other shareholders.
Learn More About Stocks and Business
I hope my article on restricted stock units was helpful. If you would like to learn more about effective business practices and how to get the most from your investments, check out The DealMakers Podcast, today.
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