What are Restricted Stock Units (RSU)?

Restricted Stock Units (RSU) is an equity compensation plan where the recipient is entitled to receive free shares sometime in the future after fulfilling certain vesting conditions. See more below

In other words, an RSU holder is not considered a shareholder until the RSU is vested and settled in shares in the company. This means that the RSU holder has no voting rights or right to receive dividends

This is an alternative way of providing ownership incentives to employees in companies. Here, too, the vesting period serves to motivate the employee to stay longer in the company. If the employee decides to leave before the vesting period expires, the employee loses the right to receive these shares. This serves to protect the company and prevent it from ending up with what is often called "dead equity" and a broken shareholder book (cap table) that can cause both frustration and make it difficult to raise external investor capital.

How does RSU work? 🤝

When a recipient is granted an RSU, he/she must decide whether he/she wishes to accept or decline the grant. The recipient must fulfill the vesting conditions before the RSUs can be settled in shares. The period is often referred to as the vesting period.

There are two main types of vesting; time-based vesting or performance/contingent vesting. The most common type of vesting in early stage companies is time-based vesting. Should the employee leave the company before the vesting period expires, the recipient loses the right to receive the free shares. It is also normal for RSUs to vest gradually during the vesting period.

Let's illustrate this with an example: If an employee is granted RSUs with a vesting period of 4 years with gradual vesting every quarter, the employee must work 4 years to be entitled to settle all RSUs. If the employee should leave the company after one year, he/she has earned the right to keep the earned RSUs if no other clauses state otherwise (1/4 of the granted RSUs). The graph below also shows that the plan has a threshold (cliff) of 12 months where nothing is earned until after this time.

The graph of the release schedule

Tax considerations 🧾

  • Since the recipient does not take any risk and receives the share free of charge, this is usually considered a benefit and is taxed as income tax when the RSUs are converted into shares. That is, not at the time of grant.
  • Only for the company: The company is required to pay employer's national insurance contributions on this amount.cf_200D↩.

Benefits of RSU 👍

  • No cost: There is no cost to receive RSUs. And shares vest at no cost when they are earned.
  • No initial risk: The RSU recipient does not have to pay anything on the grant date and therefore bears no initial risk of loss. After vesting, the tax expense must be assessed.
  • For companies: Fewer actual shareholders to report to, collect votes from and so on.cf_200D↩

Disadvantages of RSU 👎

  • Shareholder: The RSU holder does not become a shareholder until the RSU has vested and is settled
  • The RSU holder has no voting rights
  • The RSU holder is not entitled to dividends
  • Tax: All gains are taxed as income tax. This is normally higher than tax on capital income
  • The company is required to pay employer's national insurance contributions for the employee benefit.
  • Cash squeeze: When RSUs are converted into shares, the recipient must pay income tax. If the shares are not liquid (easily saleable) at the time of vesting, the recipient may have a large tax liability that they do not necessarily have free capital to pay. This is typically a challenge in private companies.cf_200D↩.

To type "Restricted Stocks"

Restricted Stock Awards (RSA) should not be confused with Restricted Stock Units (RSU). The difference is that with RSAs the recipient owns the stock (with restrictions) from the date of grant, while RSUs are a promise to receive shares in the future (after vesting) at no cost.

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