Part one of this four-part blog focused on stock option nuisances. Since we are in the middle of equity award season I’ll keep the momentum going as this blog will focus on stock options’ little sister — the Restricted Stock Unit (RSU).
How does a RSU work?
Typically, an executive’s first foray into the coveted equity pool is with some form of RSU. Basically an RSU is a stock given to an individual with a future ownership (or vesting) date. Once that occurs, the RSU is owned free and clear by the employee. Let’s take another example using DuPont. At DuPont (now DowDuPont), RSUs are typically given in February. They then vest 1/3 every year (starting on the first year anniversary). Therefore, if an executive is given 9,000 shares on February 1st 2018, the first vesting would occur on February 1st 2019 in the amount of 3,000 shares and then again the following two years. When the vesting of shares occurs they are taxed as ordinary income. At that point, most companies withhold the taxes in the form of shares. Therefore, if you’re in the 33% tax bracket, you’d be left with 2,000 shares in your account. The net value in your brokerage account becomes the value of the stock (at the time of vesting) multiplied by the amount of shares. Thus, if the shares are worth $100 at the time of vesting, your after-tax net value would be $200,000. Unlike a stock option, when the stock trading price is above zero the shares will provide an immediate value in your account as long as the company is still around when these units vest. Also, there are no additional taxes owed on appreciation from the issue date to the vesting date. You are simply taxed at the fair market value the date they vest. Once you receive RSUs for a certain number of years (in DuPont’s case four years), you’ll fall into a period of multiple vesting schedules at one time. Think of it like this: in 2021, you’ll be get the last year vesting of the 2018 tranche, the second year vesting of the 2019 tranche, and the first year vesting of the 2020 tranche. Basically, it’ll feel like you received one entire year of issue all at once!
Why do companies give RSUs?
Companies give RSUs for many of the same reasons they give stock options — to entice and keep key employees. Going back to my DuPont example, you can see if you leave the company at any point, you’ll be giving up some amount of unvested units. Typically as you are moving up the corporate food chain, the amount of units given increases. Thus they become more valuable and harder to walk away from. The other added bonus (from the company’s perspective), is that they have a way to incentivize the employee and drive the value of the stock up. Company performance directly affects the stock price. At the end of the day, it aligns senior management, executives, and (most importantly), the shareholders to whom they are beholden.
How do companies determine the value of the RSU?
Thankfully, this is less convoluted than valuing a stock option. Instead, a RSU is given to you based on current value. Let’s say your target employee bonus is 25% of your base pay. If you make $200,000/yr in base pay, that would be $50,000/yr in “bonus dollars.” If your cash bonus is $30,000, then the company would give you $20,000 in restricted units. In our example of a stock being valued at $100/share that would mean you would receive 200 shares in addition to your cash bonus.
Final thoughts on RSUs.
The life-altering ability of RSUs are less than stock options. That said, there is much more certainty and less finessing when handling them. Most people look at RSUs as “found money.” Often, I see it as a source of funds for that addition on your home or payment for your child’s college costs. RSU’s are typically given before one enters the stock option pool and generally given in conjunction with stock options once you hit a certain level. My advice is to get into this pool as soon as you can. It makes you more desirable to other companies and is typically the first sign that you’ve “arrived.”