In recent years, restricted stock units (RSUs) have grown in popularity as a way for companies to provide employee compensation that helps align the employees’ and the company’s long-term interests. The COVID-19 pandemic has helped accelerate this popularity. As one example, a client of mine needed to postpone salary raises due to recent financial challenges, so they decided to grant RSUs in lieu of those increases. Other clients have also found that the current economic environment is a good time to implement an RSU program. The specific situations vary, but a common thread is that the companies realize that issuing RSUs is often an excellent way to provide incentive compensation to employees on a no-cash basis.
One of the key reasons that RSUs are surpassing stock options as the equity compensation mode of choice is the fundamental difference between options and RSUs. Options only have value if the company’s stock increases over the value as of the date of the option grant. In contrast, RSUs will have value as long as the employee meets the vesting requirements. This is true even in the unhappy event that the stock declines in value between the date of the RSU grant and the date of settlement.
With this in mind, I thought it would be helpful to explain a few basics of RSUs. An RSU is a promise to grant stock or cash to the employee at some point in the future, typically subject to vesting requirements similar to stock option vesting requirements. A typical RSU plan gives the company the choice of either issuing stock or the equivalent amount of cash, providing the company maximum flexibility. However, when the RSU is due, most early-stage companies choose to make the grants in stock as a means of preserving cash. The tax treatment of RSUs is complex in its details, but at a high level, the structure is as follows: at the point that vesting requirements are met and any additional settlement requirements (explained below) are met: i) the employee recognizes ordinary income; and ii) the employer is required to withhold taxes as for any employment compensation.
One key advantage of RSU’s is that in addition to the usual vesting requirement, if specified in the RSU terms, settlement (i.e., actual issuance of the stock or payment of the cash) is deferred until some future defined event occurs. Typical triggers for settlement of vested RSUs include IPO and/or a change in control of the company. Until the vesting requirements are met and any other specified event take place, the employee has no rights as a shareholder. This is a key difference between RSUs and restricted stock, and it helps the company maintain a clean cap table and simplifies the company’s management of shareholder meetings, shareholder consents, etc.
As is true for any equity compensation, there are substantial critical nuances to a full understanding of RSUs. Those nuances and full understanding are vital to be able to develop an RSU plan that meets the employer’s goals and that complies with the securities and tax requirements and other regulations. For instance, one tax complication is that while income recognition by the employee and the related withholding obligation of the employer only occur when the stock is actually issued (or cash paid for cash-basis RSUs), FICA taxes and the related withholding are due upon vesting, even if actual settlement does not occur until later.
As another example of the complexity of RSUs in the tax area, depending on its specific terms, the RSU may need to comply with Internal Revenue Code § 409A. This tax law contains a detailed series of requirements for all nonqualified deferred compensation plans. If the requirements of § 409A are not met, the deferred compensation is included in current income rather than deferred (bad!), and is subject to an additional tax of twenty percent (20%) plus interest (worse!).
Potential issuers also need to comply with federal and state securities laws. RSUs constitute “securities” as defined under applicable law. As a result, any issuance of RSUs must either register as a public offering, which is to be avoided if possible, or qualify for an exemption from registration at both the federal and state level. At the federal level, the most common exemption for RSUs is SEC Rule 701, which I discussed in a previous blog. In addition, the state securities law of the issuer and any RSU recipients also need to be followed.
In summary, RSUs can be great in many situations. However, they aren’t always the best choice, as the dilution of the founders’ equity interests needs to be avoided to the extent possible. Developing a RSU plan and granting RSUs is complex. As a result, the involvement of qualified professionals is vital – this is not an area for cutting and pasting from someone else’s forms!