What are Restricted Stock Units and how do they work?
Restricted Stock Units (RSUs) are an equity compensation tool companies use to both attract and incentivize employees. They can be very valuable, but you should have a strategy for managing them once they vest.
What are Restricted Stock Units?
Restricted Stock Units (RSUs) are a type of compensation through which a company compensates an employee (usually as a performance bonus) in shares of stock.
They are issued in addition to a normal salary, not in lieu of one.
By issuing RSUs, companies can incentivize employees in several ways:
- Because the restricted stock units have a vesting period, employees are more motivated to remain employed at the company. Otherwise, they would likely surrender their RSU grants.
- Since restricted stock units are company stock, the value of the RSUs is dependent upon company performance; thereby encouraging employees to take a vested interest in the company’s success.
- Finally, many employees seek an equity stake in their company as a form of compensation. Restricted stock units can be used to attract and compete for talented employees.
Let’s walk through some RSU vocabulary, then explain in more detail how they work.
- A grant is the amount or value of stock set aside at a given time as an employee’s restricted stock unit compensation.
- A vesting date is the date the RSU grant (or some portion of it) is actually paid to the employee as compensation. This is a key milestone because it is also when restricted stock units are taxed as income.
- A vesting period is the period of time that passes between the grant date and the date the restricted stock units are given to the employee as compensation.
- A vesting schedule is the series of dates that a given RSU grant is dispersed to an employee. We’ll cover this more below, but usually, an RSU grant does not vest all in one day. Rather, it will normally vest over a series of years or months.
- A refresher grant is a fresh or new grant of RSUs that comes sometime after the initial RSU grant and is in addition to the original grant.
One of the biggest drawbacks of restricted stock units is the lack of control the recipient has over the value of the shares between the grant date and the vesting date.
This element of risk should absolutely be considered if you are offered RSUs.
For example, if you receive 1,000 shares of stock at $10/share on your grant date but the stock price drops to $5/share before the shares vest, you’ve basically lost $5,000 of compensation.
Another drawback is the vesting schedule requires you to stay with the company to receive the RSUs. If you leave prior to vesting, you forfeit any unvested shares.
To understand restricted stock units a little better, let’s walk through an example with our friend Average J.
How do RSUs work? An RSU example with our friend, Average J
As you might recall, everything that happens in Average J’s life is the product of whatever the U.S. average is for any particular subject when I write these posts.
If I can’t find a published average, I conduct an informal look around the web and use an average of those data points.
In this case, we’ll explain restricted stock units while also highlighting US averages for the unique parameters of RSUs.
Average J has been offered a job at XYZ Tech Company. In addition to his $100,000 annual cash salary, XYZ is offering Average J a sign-on RSU grant of $20,000 which vests over the course of four years.
Twenty-five percent of the RSU grant will vest annually and Average J’s initial grant will fully vest in four years.
Once the initial grant has fully vested, Average J will receive annual refresher grants worth one-quarter of the sign-on grant.
Here’s how this vesting schedule looks in a chart:
Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | Year 7 | Year 8 | ||
Sign-On Grant | $20,000.00 | $5,000.00 | $5,000.00 | $5,000.00 | $5,000.00 | ||||
Refresher Grant 1 | $5,000.00 | $1,250.00 | $1,250.00 | $1,250.00 | $1,250.00 | ||||
Refresher Grant 2 | $5,000.00 | $1,250.00 | $1,250.00 | $1,250.00 | |||||
Refresher Grant 3 | $5,000.00 | $1,250.00 | $1,250.00 | ||||||
Refresher Grant 4 | $5,000.00 | $1,250.00 | |||||||
Vested Amount |
| $5,000.00 | $5,000.00 | $5,000.00 | $5,000.00 | $1,250.00 | $2,500.00 | $3,750.00 | $5,000.00 |
Note that the amounts vested in this chart come at the end of each year.
Hopefully, this gives you some idea of how restricted stock units work and a picture of how you might evaluate them for your own situation.
There is a wide variety of approaches when it comes to RSU grants and vesting schedules.
Some companies are very generous with restricted stock units starting out, but make no promises about future grants. Others, give refresher grants annually at the same amount as the sign-on grant.
Most vesting schedules run from 3 to 5 years, but 4 seems to be the average.
Some vesting schedules vest slowly at first and increase over time.
Supposedly, one well-known tech company uses a schedule like this; vesting at 5% after year one, 15% after year two, and 40% after years 3 and 4.
Most companies appear to vest in equal amounts for each year of the vesting schedule.
Can you negotiate RSUs?
Remember that restricted stock units are a form of compensation. You should think of them that way instead of as a bonus.
As such, RSUs are absolutely an opportunity for negotiation when you’re evaluating a job offer.
Most companies will prefer to pay in restricted stock units over direct income because it doesn’t cost them any more than a direct salary, the administration of RSUs carries a relatively low cost, and it provides the employee incentives for longevity and performance we discussed earlier.
Step 1 – If you happen to receive an offer that includes RSUs, be sure to get as much information as you can about the grant amounts, vesting schedule, and refresher grants. Understanding these data points is critical to a proper evaluation.
Once you have that information, calculate the total wages you’ll receive with your salary plus any RSUs for several years into the future (similar to the table above).
Step 2 – Evaluate the potential of the company itself. Are they positioned well in their market? Do they have unique technology and prospects for growth? Are they healthy financially? Is this a stock you would buy?
If it looks like the company is in a tough financial spot, you probably shouldn’t place much value in their RSUs (or maybe even go to work there).
However, if the company is rapidly growing in an emerging market with a promising growth curve (as many tech companies do), then the RSUs could be much more valuable than the grant amounts.
Step 3 – Once you feel like you have a good idea about the company’s future, try to decide how much of your compensation you want in RSUs versus traditional salary.
If I was negotiating an offer, I’d set a minimum acceptable level for a traditional salary and look for the RSUs to act as a supplement.
For example, if I work at ABC Company for $105,000/year and get an offer from XYZ at $90,000/year plus $15,000 in RSUs over the course of 3 years, I’m going to require XYZ to come closer to matching my existing base salary.
This is because the RSU carries more risk than a base salary. At $5,000/year in vested RSUs, XYZ has only potentially matched my existing salary and I’ve incurred more risk for working there. No thanks.
Don’t be afraid to aim high if you’re being pursued by a company offering equity, but definitely don’t settle for anything less than your current guaranteed salary.
Tax Implications of RSUs
As we’ve consistently pointed out, restricted stock units are income. The IRS taxes RSUs as income at their value on the date they vest.
Typically, employers will deduct taxes from the vested amount of RSUs distributed to the employee.
The remainder belongs to the employee but is still in the form of company stock when it vests.
The employer will have a custodian that manages the brokerage account holding the RSUs.
The account belongs to the employee and is a simple taxable brokerage account. The employee is free to sell and buy as he sees fit at this point.
If the employee elects to sell the RSUs on the day they vest, he’ll only owe income tax which the employer should have already withheld.
If the employee elects to hold the shares beyond the vesting date, any gains or losses above or below the fair market value on the vesting date are now taxed as capital gains and losses.
Should I sell or hold my vested RSUs?
Ask yourself this question…
If you received an equal amount as a cash bonus today from your employer, would you go buy your company’s stock with it?
If you decide to hold on to your vested restricted stock units, that’s exactly what you’re doing. On the day they vest, you can sell them and walk away with the cash and no further tax obligation.
By holding onto the shares, you’re making a choice to use that cash value to own your company’s stock.
Now, perhaps your company is crushing it and you’re very bullish on the stock. In that case, it might make sense to hang onto your shares.
On the other hand, by receiving your income from your company you’re already highly invested in their success.
Do you want even more of your net worth attached to their market performance?
Personally, our view is to sell RSUs on the day they vest and use the funds for whatever Milestone you’re on in the Next Dollar Roadmap.
Since there’s time for the stock price to go up or down between the grant date and the vesting date, you’ll always have some exposure to the stock.
Since we try to diversify investments as opposed to concentrating them, we don’t want to accumulate too much of one company’s stock.
Especially not the one you work for.
So, there you have it, everything you need to know about RSUs. Leave your thoughts or comments below if we can improve the post somehow.
FAQs
How are RSUs taxed?
If you sell them as soon as they vest, they are completely taxed as income.
If you allow them to sit after they vest and the RSUs grow in value with the stock price, you will owe income tax on the vested amount and capital gains on any earnings over the vested amount.
How long do you have to wait to sell restricted stock?
Normally, you can sell RSUs as soon as they vest.
How many companies offer RSUs to their employees?
A 2021 survey by Deloitte showed that 86% of American companies offered RSUs in some form, but many of these companies reserve RSUs for white-collar or executive leadership roles.
Can I lose money on my RSUs?
RSUs can decrease in value between the grant date and the vesting date. They can also decline with the company’s stock price after they vest.
What happens to my RSUs if my company gets bought?
If your shares are vested, they’re yours. Period. The purchasing company will have to compensate you for your shares or substitute them with new shares of equal value.
If your RSUs haven’t vested, one of three things usually happens:
- The acquiring company cancels your RSU grants 😒;
- The acquiring company substitutes your RSU grants with new stock;
- The acquiring company gives you cash for your RSU grants;
- Some combination of 2 & 3.
The acquiring company is not under any obligation to fulfill the promise of your previous employer, but they probably won’t leave you hanging.
