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


Dan 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.

Dan Walter is the President and CEO of Performensation an
independent compensation consultant focused on the needs of small and mid-sized
public and private companies. Dan’s unique perspective and expertise includes
equity compensation, executive compensation, performance-based pay and talent
management issues. Dan is a co-author of
“The Decision Makers Guide to Equity Compensation”, “If I’d Only Know That”, “GEOnomics 2011” and “Equity Alternatives.”
Dan is on the board of the
National Center for Employee Ownership, a partner in the ShareComp virtual conferences and the founder of Equity Compensation Experts, a free networking group. Dan is frequently requested as a
dynamic and humorous speaker covering compensation and motivation topics.
Connect with him on
LinkedIn or follow
him on Twitter at
@Performensation and @SayOnPay.

 

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