ELI5

Many companies these days, particularly in tech, provide additional ways to compensate employees including options and restricted stock. We’ll touch on options in an another discussion, and will focus on a specific type of stock grants – restricted stock units or RSUs (note these are different from restricted stock awards).

RSUs are a promise made by an employer to grant an employee shares of the company at a future time. Note the word, promise. When the RSUs are granted you don’t actually own any shares until they are vested per a schedule. The terms of vesting schedule are decided by a contract agreed upon by you and your employer. One main difference between an RSU and restricted stock award is that RSU owners have no voting rights during the vesting period since they don’t actually own any shares.

Employers tend to grant RSUs as a performance incentive for employees especially during their initial compensation package. If you can hit certain performance targets, you are granted RSUs as a reward for your hard work. From the company’s perspective, these are beneficial because they are promising shares for the future, not now letting them be more financially flexible. They can choose to invest this money back into the company accelerating its growth which might lead to a higher share price in the future. 

 

Detailed Definition

It’s important to have a solid understanding of RSUs as they can be a great source of wealth generation. In addition to receiving RSUs as part of an initial compensation package, employers also distribute them as performance bonuses or promotion awards. Over time, RSUs can quickly accumulate and can potentially produce as much money as your salary (if not more). It’s typical to see executive-level employees accept RSU packages that would constitute many multiples of their base salary.

Vesting Schedule

The shares from RSUs are actually transferred to an employee as it vests. Vesting schedules tend to be time-based where shares will vest at periodic intervals. There are two typical types of vesting – cliff-based and graded.

Cliff-based is when all the granted shares vest after a set period of time. Typically tech companies have a one year cliff for a percentage of total shares granted, around 25%.

So let’s say you get 1000 shares of a company total. A one-year cliff means 250 of these shares will vest after you hit one year. This incentivizes employees to stay at the company for at least a year before considering jumping to another company, a common case in the Silicon Valley.

Graded-vesting is a form of vesting where an employee receives a percentage of shares at a fixed time intervals – monthly, quarterly, etc. Going back to the tech example above, companies typically offer graded-vesting after the one year cliff is achieved.

In our example, the other 75% of RSUs, or 750 shares, will be vested based on this graded-vesting schedule (most commonly in 12 chunks, quarterly over 3 years). Doing the math, that corresponds to 1/16 of all granted shares being vested every quarter for 3 years.

Taxes

In terms of taxation, RSUs are taxed at their market value when they vest, not when they are granted. RSUs, as they vest, are included in your W2 form. It’s important to be wary of double paying for vested RSUs! In certain cases, an employer might elect to withhold or ‘tender’ shares which are equivalent to the taxable amount.

Another tax concern is that once you own the shares and you decide to sell, you will be subjected to capital gains tax. If you sell within a year, you’ll be paying short-term capital gains tax.

If you are confident that the company is going to do well, you can choose to elect for Section 83(b). In this case, you can declare your taxable income at the time the shares are granted rather than when they vest.

For example, let’s say you are granted 20 shares at $100 in with a 1 year cliff-based vest. If you elect for 83(b), you declare 20 x $100 = $2,000 as taxable income. In 1 year, the share price moves up to $500 so you end up with a total of $10,000 worth of shares and you only had to pay taxes for $2,000 worth. If you didn’t elect for 83(b), you’d end up paying taxes on the $10,000 amount!

Be wary of the risks with the 83(b) as you have already paid taxes on shares that you might not end up receiving either due to leaving the company or the company going under.

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