What is a Restricted Stock Unit or RSU?

Restricted stock units are a popular way for companies to incentivize talent. Here’s what they are, how they work, their tax implications, and how employees can maximize their benefits. 

What is an RSU?

Restricted Stock Units (RSUs) are a type of equity compensation companies offer to their employees. RSUs represent a promise to deliver company shares to the employee at a future date, subject to conditions like continued employment and/or performance milestones. Unlike stock options, RSUs don’t require the employee to purchase the shares; they are granted outright once they vest. Vesting typically occurs over a set period, like four years, with a portion of the RSUs vesting each year.

RSUs are commonly offered in industries where attracting and retaining top talent is critical, and stock-based compensation is a significant part of the package. 

These industries include:

• Technology: Companies like Google, Facebook, and Amazon frequently offer RSUs to employees across various roles, from software engineers to product managers.
• Biotechnology and Pharmaceuticals: Firms in these sectors offer RSUs to attract scientists, researchers, and executives.
• Finance: Investment banks and financial services companies provide RSUs to high-level executives and key employees.
• Startups: Growing startups use RSUs to attract talent, compensate for lower initial salaries, and align employee interests with the company's growth.

Key terms to know

Grant date: The date the company awards RSUs to an employee. This marks the beginning of the vesting period.

Vesting schedule: Vesting is the timeline over which the RSUs become fully owned by the employee. It can be time-based, performance-based, or a combination of both.

Cliff vesting: A type of vesting schedule where a significant portion of RSUs vests after a specific period, such as one year. After the cliff, the remaining shares may vest gradually.

Time-based vesting: Vesting that occurs over a predetermined period, typically with a portion of the RSUs vesting each year or quarter.

Performance-based vesting: Vesting that depends on meeting specific performance goals or milestones the company sets.

Unvested RSUs: RSUs that have been granted but still need to meet the vesting requirements. Employees only own these shares once they vest.

Vested RSUs: RSUs that have met the vesting requirements and are now owned by the employee. These can be sold or held by the employee.

Fair Market Value (FMV): The market price of the company’s stock at a specific time, such as the vesting date. This value is used to calculate the taxable income from RSUs.

Tax withholding: The process by which the company deducts a portion of the RSUs or their cash equivalent to cover the employee’s tax liability upon vesting.

Sell to cover: A method of tax withholding where the company sells a portion of the vested shares to cover the employee’s tax obligations.

Net settlement: A method of tax withholding where the company withholds a portion of the vested shares instead of selling them—delivering the remaining shares to the employee.

Capital gains tax: The tax paid on the profit from selling RSU shares. There are short-term (for shares held less than one year) and long-term (for shares held more than one year) capital gains tax rates.

Short-term capital gains: Gains from selling RSU shares within one year of vesting, taxed at the employee’s ordinary income tax rate.

Long-term capital gains: Gains from selling RSU shares held for more than one year, typically taxed at a lower rate than short-term gains.

Lock-up period: A period after the company’s IPO during which employees cannot sell their vested shares. This is common in public companies.

Blackout period: Specific times when employees are restricted from selling their shares, often around the release of quarterly financial results to prevent insider trading.

Employee stock purchase plan (ESPP): A program that allows employees to purchase company stock at a discounted price, often through payroll deductions over a set offering period.

Equity compensation: Non-cash compensation that represents ownership in the company, including RSUs, stock options, and ESPPs.

RSUs vs. stock options:

RSUs are an alternative to stock options. Here are some key differences.

Ownership and value:

• RSUs represent a promise to deliver shares at a future date, subject to vesting conditions. Employees only own the shares once they vest. Once vested, RSUs have a clear value based on the stock price at that time.
• Stock options give employees the right to purchase shares at a predetermined price (exercise price) after they vest. The value of stock options depends on the difference between the exercise price and the stock's current market price.

Cost to employees:

• With RSUs, employees receive shares outright upon vesting without any purchase requirement.
• With stock options, employees must pay the exercise price to purchase the shares.

Taxation:

• RSUs are taxed as ordinary income when they vest based on the market value of the shares. If the value of the shares has changed, additional taxes may apply upon selling them.
• Stock options are generally not taxed at grant or vesting. Taxation occurs when the options are exercised and again upon selling the shares. The specifics depend on whether the options are Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs).

Risk and reward:

• RSUs provide a more certain value since employees receive shares outright at vesting. The risk is tied to the stock price fluctuation after vesting.
• Stock options have the potential for a higher reward if the stock price increases significantly but also a higher risk if the stock price does not exceed the exercise price, rendering the options worthless.

RSUs vs. Employee Stock Purchase Plans (ESPPs):

With RSUs, employees don’t have to make an initial investment, and shares are granted upon vesting.

With ESPPs, employees can purchase company stock at a discounted price, usually through payroll deductions over a specific offering period. Discounts and stock price performance influence the value of the purchased shares.

Many companies award RSUs and also have an ESPP plan that employees can choose to use. 

How RSUs work

When you sign an employment agreement, it will outline the terms of your RSU grant. These conditions are outlined in a vesting schedule, determining when the employee will receive the shares. 

Vesting can be time-based, where RSUs vest over a set period, or performance-based, where they vest upon achieving specific performance goals. For example, a typical vesting schedule might be four years with a one-year cliff, meaning 25% of the RSUs vest after one year, and the remaining shares vest monthly or quarterly over the next three years.

Once RSUs vest, they are converted into actual shares of the company’s stock, which the employee can sell or hold. RSUs are taxed as ordinary income based on the market value of the shares on the vesting date, with the company typically withholding taxes at this point. When the employee sells the shares, any gain or loss compared to the value at vesting is treated as a capital gain or loss. Short-term capital gains tax applies if the shares are sold within a year of vesting, and long-term capital gains tax applies if held for longer.

Here’s an example of how this works. 

Suppose an employee receives 1,000 RSUs with a 4-year vesting schedule and a 1-year cliff. After one year of employment, 250 RSUs vest. After that, 1/36th of the remaining 750 RSUs vest each month. Employees who stay with the company for the entire vesting period will receive all 1,000 shares.

Tax Implications:

• At vesting: RSUs are taxed as ordinary income based on the market value of the shares on the vesting date. The company typically withholds taxes at this point.
• Upon sale: If the employee sells the shares, any gain or loss compared to the value at vesting is treated as a capital gain or loss. Short-term capital gains apply if the shares are sold within a year of vesting; otherwise, long-term capital gains apply.

If an employee’s 250 RSUs vest when the stock price is $50 per share, the value of the vested shares is $12,500. This amount is added to the employee’s taxable income for the year. If the employee sells the shares later at $60, they will pay capital gains tax on the additional $10 per share.

A deeper look at tax implications

The primary tax events for RSUs occur at vesting and when the shares are sold. When RSUs vest, they are considered ordinary income, and their market value at the time of vesting is subject to income tax. For example, if 100 RSUs vest when the stock price is $50 per share, the employee will recognize $5,000 as ordinary income. This amount is included in the employee’s taxable income for the year. The company typically withholds a portion of the shares or cash equivalent to cover the income tax liability.

Employers usually withhold taxes to cover the employee’s income tax liability upon vesting. The withholding can be done in several ways:

• Sell to cover: A portion of the vested shares is sold to cover the taxes.
• Net settlement: The employer withholds a portion of the shares to cover the taxes.
• Cash payment: The employee pays the taxes out of pocket, and all the vested shares are delivered to the employee.

Capital gains tax

When the employee sells the shares acquired through RSUs, the transaction may result in a capital gain or loss. The difference between the sale price and the market value at the time of vesting determines the capital gain or loss. There are two types of capital gains:

• Short-term capital gains: If the shares are sold within one year of vesting, the gain is considered short-term and is taxed at the employee’s ordinary income tax rate.
• Long-term capital gains: If the shares are held for more than one year before being sold, the gain is considered long-term and is taxed at the lower long-term capital gains tax rate.

Understanding the tax implications of RSUs allows employees to plan effectively, avoid unexpected tax bills, and maximize the financial benefits of their equity compensation. Consulting with a financial advisor or tax professional can provide personalized strategies tailored to individual financial situations.

I was offered RSUs as part of my TOC. What questions should I ask?

Asking the right questions can help you understand how RSUs will impact your overall compensation, financial planning, and future earnings potential. Here are some questions to get you started. 

• What is the vesting schedule?
• How many RSUs are being offered, and how is that number determined?
• What’s the grant date?
• Are there any performance conditions attached?
• What’s the current value?
• How does the company handle tax withholding on vested RSUs?
• Is there any flexibility in the RSU vesting schedule or grant?
• Are there any restrictions on selling the vested shares?
• What’s the company’s outlook for future stock performance?
• Does the company provide financial planning resources or assistance?
• Can you provide documentation or a summary of the RSU plan?

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