Concentrated Stock Positions Series, Part 2: Restricted Stock Units (RSUs)

Marcus Dusenbury

Marcus Dusenbury
Financial Advisor and Founding Shareholder

Written by Marcus Dusenbury, Financial Advisor

So you just got restricted stock from your employer . . . now what?

Restricted Stock Units (RSUs) have become an increasingly popular corporate benefit over the past decade.  Companies recognize that their stock can effectively attract and retain talented employees.  As part of a compensation package, therefore, your employer may offer you restricted stock units, and they will have some sort of vesting schedule…but we’ll get to that in a moment.

When a company establishes a restricted stock plan, employees are offered a certain number of RSUs, and each “unit” typically corresponds to one share of company stock once the unit vests.  The “restriction” typically refers to the fact that you must hold these stock units for a certain amount of time, known as the vesting period.  Some restrictions are tied to an employee reaching certain performance metrics, but most are simply based on time of employment.  RSUs are almost always offered with a $0 cost basis to the employee, but the value of a share of stock will count as income to the employee when each RSU vests as (converts into) actual company stock.  If this all sounds complex, don’t worry; we’re going to explain it in more detail.

The Employer Perspective

Understanding why companies give employees RSUs can help you understand how they work.  Almost all RSUs are exclusively issued by publicly traded companies (i.e., companies whose stock is traded on an exchange, where anyone can buy and sell shares).  Companies use restricted stock plans as a corporate benefit package that helps attract and retain employees.

Such retention packages are sometimes called “golden handcuffs” because they provide something of real value, such as entitlement to appreciating equity in a company, in exchange for working a certain length of time. That often keeps employees working at the company longer than they otherwise might.  Indeed, RSUs have become increasingly commonplace as a means of retaining talented/key employees in industries where turnover is typically high, e.g., tech, biotech, and pharmaceuticals.

Example

Let’s look at an example of an RSU offering. Let’s say you’re offered a job in a key position at ABC Software Company.  Let’s assume that the average tenure of ABC’s new hires (at least key talent) is just 2-3 years, but the company would really like to improve that to 3-5 years.  They might create a compensation schedule for you that includes $150,000 in annual salary plus $100,000 of restricted stock units that vest over 5 years, as follows:

  • Year 1 vesting = 20% ($20,000) in stock at the end of the first year
  • Year 2 vesting = 20% ($20,000) for a total of $40,000 after two years
  • Year 3 vesting = 20% ($20,000) for a total of $60,000 after three years
  • Year 4 vesting = 20% ($20,000) for a total of $80,000 after four years
  • Year 5 vesting = 20% ($20,000) for a total of $100,000 over five years

It should be noted that the value of the shares on the vesting date will either be higher (ideally) or lower than when the RSUs were originally granted.  Thus, if an employer’s stock continues to appreciate in value over the long run, what started as a $100,000 in RSU value could be much higher years later, effectively making it more and more financially “painful” for the employee to leave the company.

It is also common for employers that are satisfied with key employees to continue to issue to them new RSUs on a regular basis, typically annually, often based on whether the employee has met the company’s goals and expectations for them.  This can keep high-performing employees from leaving for many years because they don’t want to forfeit a large amount of unvested RSU compensation.  Unless the company’s stock price declines substantially, key employees are financially motivated to continue working there.

Vesting Schedules

Restricted stock plan vesting schedules are one of the key factors that companies rely upon to keep you in their employ.  Typically, a certain percentage of restricted stock units become available each year. Some employers may have short vesting schedules that reach 100% vested after just one or two years, but four and five year vesting plans are increasingly common and more the norm.

Tax Ramifications

It is important that you know the potential tax ramifications of RSUs before any transactions occur; don’t wait to find out the tax consequences afterwards.  As an employee receiving RSUs, your cost basis is typically $0. This means that receiving an RSU costs you nothing and triggers no taxes.

It is when the units vest and become actual shares of stock in the company that they are taxed.  At that time, each RSU—now one share of stock—is taxed (at the price of the stock) to the employee as ordinary, taxable income, whether the employee decides to sell shares immediately or hang onto them.  In fact, many companies require that taxes be withheld from the shares at the time of vesting at some predetermined rate (20% is fairly common).

From the vesting date on, the employee’s cost basis in the stock is whatever its fair market value was when the RSU vested.  When the stock is sold, the difference between that vesting-date value and the price at which it is sold is then taxable as a long-term capital gain (or loss) assuming that the vesting period was longer than 1 year and 1 day.

Strategies

Negotiation
When considering a job, you can negotiate with potential employers virtually any aspect of your prospective compensation package, and that includes RSUs.  However, bear in mind that most employers—especially big-name technology employers with attractive recent stock performance—are coming from a position of power at the negotiating table, and many have therefore “standardized” their RSU offering and simply won’t negotiate.

Diversification
Putting a plan together for diversifying out of RSUs is important.  If you don’t have a plan to diversify, you will end up receiving more and more shares in just one company.  Even if it is a good company, more and more of your net worth can be tied to that one stock.  That’s not a problem as long as the stock is doing well.  But when the stock doesn’t do well, what started out as a great corporate benefit could turn into a financial nightmare and take much of your net worth with it (see history of Enron, Worldcom, and others).  The financial benefits from RSUs can be great, but make sure you create a financial plan to manage your long-term exposure to that one company’s stock.

This is another area where planning ahead can be powerful; as each batch of RSUs vests, you might:

  • sell enough shares to pay the income taxes triggered by vesting on all vesting shares;
  • keep a portion of the company shares as a longer-term investment;
  • immediately sell a portion of the shares and diversify among other good stocks and/or other securities (by doing this immediately, there will be no taxable capital gain, and future capital gains will occur among a variety of securities, allowing for selective tax planning down the road).
  • Diversifying a portion of shares each year over time can also spread the tax burden out over multiple years instead of one large tax bill all coming in once single year.

Hedging with Options
Option strategies can be complex, and the details are beyond the scope of this discussion.  However, the general idea is to use “put” and “call” options to give you the right to buy or sell a certain number of company shares, at a predetermined price, until a predetermined date.  Put options can be useful, for instance, if you have a large quantity of RSUs and want to “hedge” (protect) against the stock price declining in value while you wait for the restriction period to end (vest).  Options can thus help you to manage the risk of having too many eggs in one basket, as well as locking in gains prior to vesting periods ending.

Get Good Advice

Restricted stock plans can be fairly simple to understand, but managing RSUs effectively can require fairly complex planning. Vesting schedules, tax implications, and risk mitigation all need to be considered.  A financial professional who specializes in this area can help you develop tax and hedging strategies like those above to help manage the risks and tax implications of RSUs.

About the author: Marcus Dusenbury is a founding shareholder and fiduciary advisor with Viridian Advisors.  He has 20 years of experience working with corporate stock benefit plans including those for Intel, Expedia, Amgen, among many others.  Viridian is an SEC Registered Investment Advisor (RIA) with clients across the United States.  Viridian offers financial planning, asset management, employee benefits advice, as well as tax services through its sister company, Viridian Tax and Accounting.

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