Restricted Stock Options: the best employee equity

Restricted Stock Units surged in popularity after legislation changed in 2004, but they have been around for quite a while. The first RSU was issued in the 1800s by a railroad.

Founders don’t let founders choose stock options, I joke every so often.

Many people don’t realize how many types of equity there are to choose from, and stock options carry such significant downsides that I had to start a company to make these better stock units widely and easily available.

There are many types of equity that can be given to employees, and the best companies (Google, Microsoft, etc) are no longer giving stock options. They are now using Restricted Stock Units, which is also the equity type we’ve built Upstock with. We’re not alone in this transition. RSUs are taking off, and the most competitive companies are using them.

This is what Bill Gates said about using RSUs at Microsoft:

When you win [with options], you win the lottery. And when you don’t win, you still want it. The fact is that the variation in the value of an option is just too great. I can imagine an employee going home at night and considering two wildly different possibilities with his compensation program. Either he can buy six summer homes or no summer homes. Either he can send his kids to college 50 times, or no times. The variation is huge; much greater than most employees have an appetite for. And so as soon as they saw that options could go both ways, we proposed an economic equivalent. So what we do now is give shares, not options.

- Bill Gates

Here’s the answer to some of the most common questions about what Restricted Stock Units are and how they work.

Restricted Stock Units, as defined by Investopedia.

A restricted stock unit (RSU) is compensation issued by an employer to an employee in the form of company stock. Restricted stock units are issued to an employee through a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with their employer for a particular length of time.

Restricted stock as a form of executive compensation became more popular after accounting scandals in the mid-2000s involving companies like Enron and WorldCom as a better alternative to stock options.

At the end of 2004, the Financial Accounting Standards Board (FASB) issued a statement requiring companies to book an accounting expense for stock options issued. This action leveled the playing field among equity types. Previously, stock options had been the vehicle of choice, but with scandals, malpractice, and issues of tax-evasion, companies were (as of 2004) able to consider other types of stock awards that might be more effective in attracting and retaining talent.

How does a Restricted Stock Unit (RSU) work?

RSUs are a promise to issue stock at a certain point in the future upon settlement of the RSUs when certain conditions are met and the vesting requirements are satisfied. Usually those are that the worker has earned them over a certain period of time and that the company was successful (was acquired or had an IPO) also called a Landmark Event. Once any shares have been issued to the worker, they then own them outright and it is subject to the company’s insider trading policy if the worker holds, sells or otherwise disposes of them. What makes RSUs stand out is that workers do not have to pay tax when the RSUs are promised. Only when there is cash to pay the tax are the RSUs converted into actual stock. The stock of course is then taxable as income at the market value upon conversion.

What is the difference between RSUs and Stock Options?

We have published a longer article with more detailed information you can peruse. At the core though, there are two significant differences that most people find to be decision-points.

1. RSUs are considered more valuable and less risky than stock options. RSUs are always worth something and don’t go “under water” like options can. The RSU awards retain value, regardless of the performance of the company’s stock price (unless it goes to zero). The value of the RSUs do not depend on the company’s stock price. If it is lower today than it was at the time it was awarded then the worker still have the ability to settle the award into actual stock with a value, which is not the case with the options.
2. In most cases options are taxed as income at the time of exercise, regardless of whether shares are sold or held. Taxes on gains also may need to be paid upon subsequent sale of shares. RSUs are generally taxed when they vest. This means the tax is due when there is money to pay for it. RSUs are also a lot simpler for owners to manage from a legal and tax perspective.

What is an Award Agreement?

The Award Agreement is a legal document which describes your award’s terms and conditions, such as the equity rate the team member will be earning and the vesting requirements.

How are RSUs taxed?

When you receive an RSU, you don’t have any immediate tax liability. RSUs are taxed upon settlement, that is, when the shares are actually delivered or when you take the actual ownership of the shares. This is the key difference that makes RSUs stand out from both stock and stock options. They allow you to defer tax until a later date when money is available. If the company is not successful, the worker won’t lose all the money on tax before it folds. The fair market value of the shares at settlement is a deciding factor of the taxable income.

Please note that Upstock does not provide tax advice and assumes no liability if you rely on it. Upstock recommends that you seek your own independent tax advice for more information about how RSUs will affect your tax liability.

What happens to the RSUs when someone leaves a company?

Your company has offered you the opportunity to be part of an equity pool because they believe in you and would like you to be committed long term. Having said that people do come and go from companies and your efforts should still be rewarded. The RSUs will still vest on a landmark event if you have also met the service period condition which is set out in the Award Agreement with the company and in this case your vested RSUs remain yours until you choose to sell them. However, If you left due to a grievous reason or your RSUs are still unvested your award will be forfeited.

What happens to unvested RSUs in case of a company sale?

The terms of the company Performance Equity Plan and Award Agreement give information what happens to the RSUs. Typically RSUs will vest upon a company sale or other qualifying event known as a Landmark Event so long as a team member has been with the company for the qualifying period and there has been no termination for a grievous cause.

Upstock combines RSUs, performance equity, and a visual dashboard to make teams become more aligned. With UpStock’s dashboards you can easily visualize how your equity grows in real time and know that your efforts actually count. There are no initial legal costs for the business owner or team members, and you are given a full set of legal documents created by the best legal minds in the world. To learn more, visit upstock.io or contact our team.