Stock Plans/Equity

The Human Capitalist Series P.6: Restricted Stock Units

Restricted stock units (RSUs) are rights to acquire stock without paying an exercise or purchase price. Vesting and settlement must comply with Internal Revenue Code Section 409A. Generally, shares must be issued (and taxation triggered) shortly after the vesting date. While private companies commonly use a liquidity event as a vesting trigger for RSUs in order to defer taxation until there is liquidity, care must be taken at the time of grant to determine whether the liquidity event constitutes a substantial risk of forfeiture under Section 409A. Alternatively, RSUs can be structured to comply with Section 409A deferred compensation rules.

General Pros and Cons of RSUs

  • Pro: There is no purchase price to pay.
  • Pro: Because the holder receives the “full value” of the award, companies tend to grant fewer shares subject to RSUs, thereby reducing the potential dilution to stockholders.
  • Pro: For sophisticated award recipients, a deferral provision (deferral of income taxes) may be a positive employee benefit. However, the company may be required to withhold payroll taxes on RSUs shortly after vesting, even if the shares won’t be issued until later.
  • Con: Ordinary income taxes are due on the full fair market value of the share at vesting (or, if later, shortly thereafter, when the shares are issued), with tax withholding due promptly after vesting—generally not later than March 15 of the year following the year of vesting. Companies and award holders may not have sufficient funds to pay taxes, especially if the company’s stock is not publicly traded (including during a lock-up period).
  • Con: If the stock is publicly traded at vesting, having a large number of awards vesting at the same time may cause downward pressure on the company’s stock price as award holders flood the market with shares to sell to cover their tax obligations.
  • Con: If the vesting trigger (e.g., the definition of “Good Reason,” or the use of either an initial public offering (IPO) or change of control during the life of the award as a vesting trigger) is not a substantial risk of forfeiture under Section 409A, the award holder may owe a 20% penalty tax on the value of the RSU in addition to income and employment taxes, even if there is no liquidity in the stock.
  • Con: If a liquidity event is a trigger for vesting, the occurrence of the liquidity event during the life of the RSU award must be substantially uncertain to occur, as determined on the grant date. For example, if the company is telling investors that liquidity should be expected in the next three years, it may be difficult to argue that an IPO or change of control is a substantial risk of forfeiture under Section 409A if the award has a term of greater than three years.

Accounting Treatment—RSUs

The value of an RSU award that has time-based vesting is measured on the grant date based on the number of shares subject to the RSU award and the current fair market value per share of stock. This value is recognized for financial statement purposes over the vesting period as a non-cash compensation expense.

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