Equity Compensation – Restricted Stock Units (RSUs), Downside Protection with a Couple Downsides

stickman - equity compensation - rsuDan Walter, Performensation

Last month I covered Restricted Stock Shares (RSS), today’s post covers Restricted Stock Units (RSUs). Where RSS and Stock Options are cousins, RSS and RSUs are siblings. RSS is the older sibling, with more years and experience under its belt. RSUs are the new little sister who came by surprise and often gets more attention than seems to be required. RSUs were seldom used before they shot into the spotlight following the Dotcom crash of 1999-2000. Initially, they were used to replace underwater stock options and slow the use of plan shares approved by shareholders. They provided some protection against a decrease in stock price and used somewhere between 25-50% of the shares require to provide the same value as stock options. They quickly became a major component of the equity compensation toolbox.

RSUs are generally “full value” awards, meaning that they have no purchase or exercise cost to the participant. Unlike RSS, RSUs do not require the issuance of real shares until the units are vested. This is why they are called “units” rather than shares. Many companies use the term “Award” to refer to RSUs, RSS and any other full value instrument. This separates them from the “grant” of appreciation-only instruments like ISOs, NQSOs and SARs. Either term can be used interchangeably. RSUs live in the interesting middle ground between real restricted stock and stock options to purchase shares in the future.

It is also important to note that although the majority of RSUs are designed to settle in stock, these awards can also be designed to allow, or require, settlement in cash. Cash settlement has the upside of not diluting other shareholders’ ownership position and the downside of requiring variable accounting.

As general rule, participants do not have any income from RSUs at the time of award. The ordinary income event occurs when the units vest and shares are delivered. At the time of vest the company is obligated to withhold income and employment taxes for eligible employees.

RSUs fall under IRC 409A, the deferred income and taxation rules. Even private companies need to have a reasonable basis for the value of their stock if they wish to use these awards. It also means that one of the key potential benefits of RSUs, the elective deferral of income, is subject to restrictions that make the process onerous for both participants and companies. Because of this, many companies no longer allow participants to make deferral elections. Another downside: Unlike RSS, participants can’t file an 83(b) election to accelerate income to a time when the spread is very low. Unlike Stock Options, participants do not get to elect when, in the future, the income and tax event takes place. This lack of income and tax planning flexibility is important.

In spite of the downsides, RSUs are a great tool. Because they do not require the immediate issuance of stock, companies can avoid creating instant shareholders and paying ongoing dividends. If the individual leaves with unvested units, the company can easily cancel them rather than go through the process of forfeiture and repurchase. They are an excellent retention tool in companies with an ownership culture and can provide a simple way to provide equity to broad-based participants around the world (we will cover international aspects in a later post).

Like any equity compensation tool RSUs, do not work perfectly as the “only” equity compensation tool for any company. As we explore this equity compensation series the first Thursday of every month we will discuss other tools and way these tools can be used together to provide a complete solution to your company’s needs.

This was original posted on the PayScale Compensation Today blog