Restricted Stock Units: What You Should Know

Restricted Stock Units: What You Should Know

For most US startups, stock options are the primary form of equity offered to employees and other service providers. Our startup clients – especially later-stage private companies – frequently ask us when and whether they should shift to restricted stock units, commonly known as RSUs.

This article explains what RSUs are, considers why some companies choose to grant RSUs and discusses some of the potential issues associated with RSUs. Please note that any discussion of tax considerations is meant in the context of RSUs issued by US companies to US taxpayers.

What are RSUs, and how do they work?

Basic mechanics

An RSU is a contractual right to receive, upon satisfaction of all vesting conditions, a specified number of shares of a company’s stock. Unlike stock options, there is no need to exercise an RSU, and there is no “exercise price” that the recipient must pay for the stock. Instead, the RSU holder automatically receives the shares once the vesting conditions are satisfied. That issuance of shares is sometimes referred to as the “settlement” of RSUs, and the value of the settled shares is taxable to the recipient in the US.

RSUs should not be confused with restricted stock awards (RSAs). RSAs are a different type of equity incentive, where stock is immediately transferred to the service provider at grant either for cash or in exchange for services. (That grant is usually subject to reverse vesting, i.e., the unvested portion of the grant can be repurchased by the company at nominal cost upon termination of service.)

For most US startups, RSAs are used only at or around the time of incorporation and before the company has raised capital (i.e., when the startup can credibly claim the value of the stock is very low). Many startups switch to stock options from RSAs following their first preferred stock financing, if not sooner.

Vesting and US income tax considerations

RSUs granted by private companies are typically structured with “double trigger” vesting – two vesting conditions that must both be satisfied for the RSUs to vest. The first condition is a time-based condition similar to that frequently found in stock options (i.e., this condition vests over time based on continued services being provided by the holder). The second condition is a performance-based condition (typically the occurrence of a liquidity event: either an IPO or acquisition of the company). In the US, because the shares issued on settlement of RSUs are taxable when delivered to the holder of an RSU upon full vesting, private companies incorporate the second performance-based condition to defer full vesting/settlement (and therefore taxation) until a later event that will result in liquidity of the underlying shares so the holder has the means to fund the resulting US income tax withholding obligations.

To illustrate this point, consider an employee who is an RSU holder who, upon settlement, would receive shares in her private company employer worth $10,000. In connection with RSU settlement, the company is required to withhold and remit taxes to the IRS on the fair market value of the transferred shares (i.e., $10,000). Because the shares are illiquid private company stock, the employee would not be able to sell a portion of her shares to cover the resulting US income tax obligation. To avoid a situation where she needs to come out of pocket to pay income tax withholding on the shares (often referred to as a “dry tax”), her RSUs are structured with the second performance condition to settle the RSUs later (in connection with a liquidity event), at which time she would have the ability to cover the US withholding taxes. In other words, satisfying the time-based condition does not alone trigger settlement; she still needs to wait for the subsequent liquidity event.

It is also important to keep in mind that while the employee bears economic responsibility for this US income tax, the company has the obligation to withhold and remit in cash the withholding amounts to the IRS – and the resulting penalties for failing to comply with this obligation are assessed against the company. Even if the company were to withhold shares from the employee to cover the US withholding tax liability at settlement of the RSU, the company would have to remit the cash to cover the US withholding tax liability to the government using cash on its balance sheet. (Such use of balance sheet cash would be problematic for most startups).

Some, but not all, RSUs are structured so that the shares will only vest and be settled if the employee is still working for the company when the liquidity event occurs (even if the employee has fully satisfied the time-based vesting condition). The inclusion of this requirement is driven by both technical US tax law requirements and business considerations. Companies should discuss the appropriate structure for their RSUs with their legal counsel.

Time-based vesting condition applicable to RSU grants usually follows the vesting cadence applicable to stock options (e.g., four-year total vesting with a one-year cliff for new hire awards often followed by monthly vesting). However, to reduce administrative burden following an IPO, it is critical to grant RSUs with a more uniform schedule (e.g., quarterly vesting on the same date for all employees versus various dates tied to the commencement of services or the applicable grant date).

When do companies start to consider RSUs?

Companies will sometimes start to consider RSUs when there is a sense that its existing options are becoming ineffective to motivate and compensate employees. This may be because the exercise price of newly granted options has become so high that employees are concerned they will not be able to pay it. Or, the company’s value may be seen as speculative (for example, if its valuation has fluctuated), making its employees concerned that option grants may be “underwater” or “out of the money” – i.e., the option exercise price may turn out to be higher than the fair market value of the underlying stock.

Because RSUs do not have an exercise price, they generally always have value, even if the value of the company declines after the RSU grant. For this reason, RSUs are often referred to as “full value” awards.

Companies also sometimes consider RSUs when their option pool reserve is running low or when they have granted a significant amount of incentive equity and dilution is a concern. Because RSU recipients receive the full value of the underlying stock without having to pay an exercise price, companies can deliver the same grant date value using fewer shares with RSUs than with options.

What are some of the issues to be aware of with RSUs?

While RSUs have some attractive features, they are complex and can lead to unintended consequences. Below are some important issues to think about when considering RSUs.

• US tax and withholding. As noted above, the receipt of shares upon settlement of an RSU is treated as ordinary income for US tax purposes – as opposed to long-term capital gains – even if the recipient has held the RSU for years. Relatedly, recipients cannot file 83(b) elections or control the time at which they receive US taxable income. Further, companies will have withholding obligations upon settlement. RSUs need to be carefully structured to avoid or mitigate adverse tax consequences for both the company and the RSU recipients.
• Speculative value. While RSUs cannot be “underwater” in the same way as options (again, because they do not have an exercise price), they can still end up being essentially valueless if the company doesn’t get sold or go public during the term of the RSU (which is often seven years). This can especially be the case for companies that may be more than a year or two away from an anticipated liquidity event. For this reason, you rarely see RSUs issued by early-stage startups.
• Secondaries. Unlike stock options, RSUs have (at most) a limited ability to participate in secondary transactions. The considerations regarding RSUs in liquidity transactions are discussed further in another Cooley GO article.
• Disclosure obligations.
• If former service providers continue to hold RSUs after they leave the company, they may become entitled to receive company information under Rule 701 of the Securities Act. In some cases, this can lead to the company having to provide its financial statements to a former employee who is now working for a competitor.
• Employee education. RSUs are less common than stock options, so companies may need to educate employees on RSUs and how they work, especially the applicable US tax treatment.

Because of these complexities and issues, if you are considering issuing RSUs, you should speak with your attorneys, tax advisors and accountants early on to understand the pros and cons and, if you proceed, determine how the RSUs should be structured.