Understanding Restricted Stock Units (RSUs) Basics
By Lior_Ronen | Founder, Finro Financial Consulting
Many companies give employees equity- or stock-based benefits in compensation packages.
Equity compensation is an excellent addition to employees' paychecks that increases their compensation and gives them the incentive to stay with the company and contribute to its success.
Packages of equity compensation can include different forms of compensation such as restricted stock units (RSU), restricted stock awards (RSA), or other types of stock options.
Stock options and RSUs have many similarities, but the main difference between them is that RSUs don't have an exercise price mechanism. Let's see what it means.
Typically, the employee is granted a certain number of stock options with an exercise price. If the price of the stock was below that exercise price, the options were below the water, which means that they cannot be converted to shares. However, once the stock price is higher than the exercise price in the options contract, the stock options are above water and could be converted into shares and potential cash.
That mechanism created endless attempts to artificially and retrospectively alter the exercise price on some options contracts.
While stock options were trendy years ago, many companies and executives have tried to stay away from stock options since the 2006 backdating scandal.
RSU has become significantly more common since then, and they are currently the primary form of equity compensation companies provide.
RSAs are another form of stock-based compensation that is very similar to RSUs. However, while RSU companies issue new stocks to employees, in RSA, employees are awarded existing shares. Since RSA are slightly more rare than RSU, we will not discuss them in this post.
What are Restricted Stock Units (RSUs)?
RSUs are a type of stock compensation issued by a company to an employee in the form of shares.
These shares are locked for a certain period of time and released to the employee gradually according to the vesting plan and distribution schedule.
RSUs are a great way to incentivize employees to remain in the company and contribute to its success.
Let's see how it works.
RSUs are typically issued with a few essential terms:
The number of units available to the employee.
Vesting period: This is a certain period of time companies often require their employees to stay with the company before their RSU vest. Typically, the vesting period is four years, but it could vary according to the company.
Distribution schedule: while companies set a certain vesting period for the entire RSU package, portions of that package are typically released to the employee at a particular schedule.
Vesting cliff: The minimum amount of time an employee needs to stay in the company to start exercising the distributed units.
Liquidity event: Employees of public companies can easily exercise their RSUs by selling them at the open market price. Employees of private companies cannot do this since their company's shares are not publicly available. They must wait for a specific liquidation event before they can receive cash for their units.
RSU Distribution Example
Let's assume an employee of a publicly-traded company receives 1,000 RSUs with a vesting period of 4 years and a 25% annual distribution.
Right now, the employee has 1,000 units of unvested RSU.
After one year at the company, the employee now receives 250 units of vested RSUs, and still has 750 units of unvested units.
After two years, the employee has 500 units of vested RSUs and 500 units of unvested RSUs.
After three years, the employee has 750 of vested RSUs and 250 units of unvested RSUs.
After four years, all the RSUs vested and distributed.
What happens if the employee leave the company before their fourth year is up?
Depending on the package's terms, your vested units can be exercised before you leave the company. These units will terminate when the employment terminates.