As you progress in your career, especially if you work in corporate America, one of the first changes you see is in your compensation. Instead of simply getting an increase in pay, corporations often incentivize their employees, and attract new hires, by offering equity - or the opportunity to buy equity - in the corporation.
To that end, we're kicking off a series walking you through the different types of equity-based compensation and employee benefits.
If you're needing to read these articles to figure out what's being offered to you, then congratulations, because being offered equity-based pay means you're likely on that right track professionally! Hopefully these posts provide some clarity and allow you to form an action plan.
In Part 1, let's kick things off with Restricted Stock Units, or RSUs for short.
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In discussing equity-based pay, it's easiest if we break it into two categories:
- Will Be Yours: equity in the company that you WILL have if you meet certain conditions
- Could Be Yours: equity in the company that could be yours if you meet certain conditions AND have the money to pay for it
Restricted Stock Units are a 'Will Be Yours' benefit. RSUs represent pay given to you by the corporation in the form of company stock. Your ability to buy and sell that stock, however, is restricted by when they are distributed/granted to you and when they vest.
RSUs can be distributed, or "granted", to you at certain key points, like when you're hired, when you're promoted or when you're negotiating a raise. As an example, if you're hired for a position, you could be granted 1,000 shares of common stock at the time of your hiring. This doesn't mean that these shares are yours to do with what you please. In order for them to be truly yours, these shares must also be vested.
Vested simply means you have full ownership of the shares, without restrictions. Typically corporations distribute RSUs that are accompanied by a vesting schedule that determines how long the employee must wait to have full ownership of the shares.
Vesting schedules make perfect sense when you think about it: the company is granting you equity in the hopes that you stay with them for an extended period of time. If you had full ownership of your granted shares immediately, there would be no incentive to stay and work for the company! By spreading out the vesting of the shares over 3 or 4 years, the employee has to stay and work for that length of time, otherwise they forfeit any shares that have yet to vest.
It's also important to discuss the taxation of equity-based compensation. For 'Will Be Yours' benefits like RSUs, initial taxation occurs whenever the shares are in your complete control. When they are granted, you do not yet have ownership rights of the stock, so there is no taxation. When they vest, you have now been paid in the eyes of the IRS, even if the pay isn't in pure cash. And that compensation is taxable to you as income at the time payment occurs.
Let's look at an example of an employee granted 2,000 shares of common stock in their company, with a current value of $100 per share, vested quarterly over a 4 year time period:
Since $12,500 worth of shares vested in this quarter, our employee has earned that amount for tax purposes. When they file their taxes it will essentially be part of their salary, even though they cannot spend it like cash while it's in the form of stock.
At some point, for reasons we'll cover below, a person with RSUs may want to be able to sell their shares, which is where the second tax question comes into play: is the sale of stock a long-term or a short-term capital gain?
What is a Short-Term Capital Gain?
A short-term capital gain occurs when an investment is sold at a profit after being owned/held for less than one year. Short-term capital gains are taxed at the ordinary income rate of the seller, simply meaning it is subject to the same taxes as your regular pay.
The preferable way to sell RSUs is when they'll be considered long-term capital gains.
What is a Long-Term Capital Gain?
Long-term capital gains occur when investments are sold at a profit after being held longer than one year. When a long-term capital gain occurs, the profit is taxed at either 15% or 20% depending on your income, rates which are often lower than your ordinary income tax rate.
Since RSUs typically vest over an extended period of time, employees who want to sell some of their stock and be assured any gains are long-term capital gains can't sell all their shares at once. They instead must wait for each block of shares are vested for more than a year before they can be sold. Oftentimes this means forming a set schedule for selling off shares after they've been vested for at least a year and a day.
Let's go back to our employee who was granted 2,000 RSUs that vest quarterly over a 4-year period, meaning that 125 shares vests each quarter:
You can see that even though 500 shares vest in the first year, the employee would have to wait until January 1st, 2024 at the earliest to be able to sell all 500 of these shares for a profit that would be treated as a long-term capital gain. Should they sell before that date, they would risk paying short-term capital gains rates - i.e., their regular income tax rates - on a portion of their profits.
Let's see an example, and we'll assume our seller is in the 32% tax bracket for ordinary income and the 15% bracket for long-term capital gains:
While it's great that shares could be sold at a profit, by this point only half of the shares had been vested for over a year, meaning the profit will be taxed at a much higher rate as a short-term capital gain.
Does It Ever Make Sense To Sell RSUs As A Short-Term Capital Gain?
If it seems like this person is being foolish and there's no logical reason a person would sell their RSUs within a year, you'd be wrong.
Many top companies, like the Apples, Googles and Facebooks of the world, use RSUs as a standard part of compensation for their highly-compensated employees. In many cases, these companies have annual employee reviews where they not only review job performance, but also the makeup of any increases in compensation. During these compensation conversations, the number of additional RSUs an employee might be granted as a part of their raise is as much a part of the conversation as the increase in actual salary. As a matter of fact, it's not uncommon during these negotiations for an employee who believes strongly in the company's growth prospects to sacrifice a salary increase in exchange for more RSUs!
Why is this relevant when discussing a time it might make sense to sell RSUs early and subject yourself to short-term capital gains? Because another thing these major companies have in common is that they operate in areas with an extremely high cost of living. As amazing at is sounds to have a salary of $300,000 or $400,000, those amounts don't stretch as far as you might think in areas like Seattle and Silicon Valley. And rather than having to pony up more cash to pay their executives, these corporations will grant more RSUs with the expectation that the executive will cash out a portion of them immediately so they can live off the proceeds as if they were salary.
When you cash out the RSUs immediately after they've been granted, there's been no opportunity for the price of stock to appreciate. Thus, you'd simply be paying short-term capital gains rate - which is your ordinary tax rate - on the value of the stock granted to you. Meaning if you're granted $10,000 worth of RSUs and sell them immediately, the tax impact is similar to simply receiving $10,000 in cash from the company, except with the RSUs they didn't have to give you actual cash. It's a ridiculously cheap way for multi-billion dollar corporations to do business, but it's the name of the game. So much so that these businesses will allow their employees' RSUs to vest at a more frequent pace so that the recipient can more quickly convert them to cash that can be used to pay their expenses.
Let's look at an example:
Even though the same number of shares are granted in each case, the quarterly vesting schedule would be problematic if our employee is depending on the value of the RSUs to fund their monthly cashflow needs. By offering monthly vesting, the corporation is acknowledging that even through their workforce may keep a portion of their RSUs in hopes that they increase in value, they are likely to cash out another portion to be able to cover their expenses.
On the employee side, cashing out RSUs immediately is a fine line between making sure you have enough money to live, and betting on the future of the company. Every share you cash out immediately is a share you don't get to see appreciate in value in your portfolio, meaning you're potentially sacrificing a wealth event later for an immediate cashflow need.
Can private companies offer RSUs?
While private companies can absolutely offer RSUs, another form of equity-based compensation called stock options are more likely for a company in its early stages of growth. As you'll see in our post covering stock options during this series, one reason this is the case is stock options come at a lower expense to an early stage company than an RSU, and represent a larger risk to the employee if the company either never goes public or goes public at a valuation much lower than expected.
The closer a company gets to going public, however, RSUs might be offered more frequently. When offered by a private company that hopes to go public, RSUs often have what's considered double-trigger vesting.
What Is Double-Trigger Vesting?
Double-trigger vesting, or accelerated vesting, is when the vesting of your shares can be "accelerated" ahead of the time requirements laid out in your vesting schedule if two named events ("double triggers") occur.
The most common named events for private companies offering RSUs with double-trigger vesting are, 1.) the company going public in an Initial Public Offering (IPO) or being acquired, and 2.) The employee being terminated as a result of the acquisition/IPO.
Both triggers must occur in order for the vesting to accelerate, otherwise the remaining shares will vest according to their original schedule. When an investor acquires a company or participates in its IPO, it expects continuity in the operations and management of said company following the investment. The only requirement for accelerated vesting was the acquisition/IPO itself, employees and managers could quit and take the profits from there now-vested shares without penalty. By pairing this event with the requirement the employee also be terminated, the investor is protected, and a small silver lining has been offered to any workers who don't survive the transition. They were terminated, but at least they can take all of their granted shares with them as they leave. Brutal, I know, but this is corporate America!
Let's take a look at an example of two employees holding RSUs with double-trigger vesting in a private company do to go public in the next two years:
Employee One has unvested shares and has only met one of the two triggers needed to accelerate the vesting of their remaining shares. As a result, they cannot leave the company until the requirements of the original vesting schedule have been met, otherwise the unvested shares are forfeited.
Employee Two, however, was terminated as a result of the IPO. They have now met both of the two triggers, and their remaining shares will immediately vest.
So… How Do We Evaluate RSUs?
All RSUs are not created equally. There are number of questions you must ask yourself if RSUs are being offered to you as a new hire or as part of a new compensation package:
Do you believe in the long-term growth prospects of the company?
RSUs are worth real money the second your shares vest, so they have the value even if your plan is to immediately cash them in. For most people, however, the hope is that the share price of their company increases significantly over time, which could lead to a major wealth event if you're holding a bunch of shares. But if you take a job with a company you don't believe will grow, or may be able even decline in value, the utility of your RSUs will decline as well.
Do you plan to be there long enough for all your shares to vest?
Even if you believe before every single one of your shares has vested, there can still be a benefit in working at the company. Should you take a job for two years that was the right fit for you at the time and offered you the opportunity to stick some RSUs in your portfolio before you moved on to the next thing, it's not the end of the world if there are some unvested shares on the table. It does however, shape the true value of the offer if you don't plan to stay long enough to reap its full reward. Consider these factors when evaluating the position: if you're granted $200,000 worth of RSUs but plan to leave after only $75,000 has vested, then $75,000 is the true offer.
Do you think the company will ever go public? (Private company)
A company doesn't have to go public for you to benefit from owning RSUs. Private companies can offer employees with stock options and RSUs the right to sell their shares back to the company at their current valuation. So while you are not without recourse, the hope of a company offering this compensation is certainly that they would one day go public.
What percentage of my vested shares do I plan to keep?
Let's assume the best happens, the share price of your RSUs explodes in value. Maybe the shares you are granted were worse $50,000 at grant and now they're worse $3 million (it can happen and has happened). While it's a good problem to have, you would likely be in a position where the overwhelming majority of your portfolio is now dependent upon the fortunes of a single company. As an advisor counseling a client in this position, I would likely recommend that cash out a portion of their shares so the proceeds could be reinvested in a more diversified portfolio. It would be up to you to determine how much risk you want to stake in staking your future fortune on the fate of the company that created the fortune in the first place, but it's worth thinking about it even before it occurs. Some employees have a set percentage of RSUs they keep and RSUs they sell each year, holding on to 50% or 60% and diversifying the remaining amounts in other investments.
Who will help me manage the implications of my RSUs?
This isn't a plug for ME as a financial advisor, or for a CPA I know. It's a plug for you staying out of harm's way by wheeling and dealing RSUs without knowing the impact on your taxes, your other investments, and your wealth prospects as a whole. There are many people who may not need a financial advisor or a professional tax preparer, but if you're dealing with valuable RSUs, my (informed) opinion is that you need the help. So find somebody you trust and form a plan of action for how to deal with the particulars.
I hope you enjoyed this post and that it provided clarity on the inner workings of restricted stock. Stay tuned for part 2 of our series on equity compensation: Stock Options!