The post Restricted Stock Units: A Tool for Retaining Top Talent by Chika Uchendu appeared first on Benzinga. Visit Benzinga to get more great content like this.

One of the most efficient approaches modern corporations adopt to ensure employee retention is providing adequate employee compensation. Workers appreciate being well-compensated for the time and effort they put into the growth of an organization.

Amy Roy, the chief people officer (CPO) at Namely, listed standard employee compensation packages to include cash, equity and non-cash payments like insurance benefits and other perks. Compensation types vary among firms and may depend on job descriptions and employee hierarchy.

For instance, small businesses may offer commissions and insurance benefits besides the basic salary. In addition to the essentials provided by small companies, big corporations may also offer equity compensation — stock options or restricted stock units (RSUs).

Formerly reserved for higher-level management in an organization, RSUs became a common alternative to stock options after the accounting scandals of the mid-2000s. It has since become the favorite employee equity compensation for top American corporations like Microsoft, Alphabet and Amazon. For instance, in a 2019 domestic stock plan design survey by Deloitte, 92% of the respondent companies granted restricted stock units compared to 54% for stock options.

Benzinga looks into restricted stock options, providing deeper insight into how they work and how they might be an excellent option to add to your employee compensation scheme.

What is a Restricted Stock Unit?

An RSU is a company’s stock award subject to conditions, usually a vesting period before being transferred to the employee. Although RSUs grant employees a stake in the company’s stock, it lacks tangible value until vesting.

Like stock options, RSUs vest over time. However, unlike stock options, employees don’t have to buy RSUs. The term restricted arises from the fact that the stock unit is subject to a vesting schedule or governed by other limits on sales or transfers that the corporation may impose.

Vesting Schedule

The vesting schedule is often based on the length of employment (time-based vesting) and mandates you to work in the organization for a specific duration before vesting. Nevertheless, it can also be based on performance goals (milestone-based), which are measurable using agreed key performance indicators (KPIs) like stock-market or company-specific targets. Grants made before a private company’s initial public offering (IPO) may also necessitate a liquidity event (i.e., the IPO itself) before the stock units vest.

Time-Based Vesting Schedule

A time-based vesting schedule can either be graded or cliff. A graded vesting schedule involves the vesting of the stock grant in a serial order. Suppose Christine, a back-end developer for Benzinga, is granted 5,000 RSUs of the company in a graded vesting schedule that spans five years, and 20% of the grants vest annually. In that case, at the first anniversary of her grant vest, 1,000 units (20% of 5,000) of the shares vest. The exact quantity of shares vest till her fifth anniversary. Christine can decide to sell each portion of the shares as they vest.

Graded Vesting Schedule

A graded vesting schedule may, in addition to providing for regular vesting, have varying intervals between vesting dates. For instance, Benzinga may grant Christine 4,000 RSUs of the company spanning four years, and 50% of the company shares vest after two years. The other 2,000 RSUs vest every month over the remaining years. Unlike graded vesting schedules, 100% of the stock grants vest once you satisfy the stated conditions in a cliff vesting schedule.

In all cases, once all conditions are satisfied, the stocks become non-restricted and can be treated as if bought from the open stock market. Share vesting halts on job termination, except if termination results from death, disability or retirement. In this case, vesting may be accelerated depending on your plan or grant agreement.

Who Benefits From Restricted Stock Units?

RSUs benefit the employer and employee in various ways. Its core benefits to the employees include:

Low-Risk Equity

RSUs are highly valuable equity grants with lower risk than stock options. When a company’s stock price declines, stock options go underwater and lose practically all their value, especially if the strike price is far above the common stock’s market value. In contrast, RSUs are always worth something, even when the company’s stock price drops below that on the grant date. RSUs mean that there is little to no need for the award recipient to pay constant attention since they do not have to be worried about whether the award recipient will get a good exercise price.

For instance, say your company grants you 1,500 RSUs when its share price is $550, and by the time the shares vest, it has fallen to $500. Your grant will still be worth $750,000 before tax.

So the certainty of RSUs value makes it appealing to new employees as a hiring bonus or compensation for pay and benefits.

Clear Valuation

An RSU is one of the simplest types of equity compensation to value. You can quickly figure out or calculate its monetary value in your pocket compared to the theoretical stock options value. You can calculate your RSU value by multiplying it by the stock’s fair market value.

Current market value = RSUs X Stock Price

However, you must understand that this valuation is only a future promise until the shares vest. And the valuation may change at the time of vesting because a company’s stock price changes.

Fewer Decisions

Compared to other equity compensations, including non-qualified and employee stock options, RSUs are relatively easier to deal with. The reason is that core decisions are made for you rather than by you. With employee stock options, you must decide when (and if) to exercise your options and the exercise method to apply. This decision is often made complex by several factors, including income tax, valuation, cash flow requirements and market timing.

As a result, confusion may arise, leading to wrong decisions or total inaction — a considerable problem since options expire. However, with RSUs, the vesting schedule, the fair market value (FMV) you receive and the tax withholding occur without your intervention or decision-making. These factors make it easier to take advantage of your equity award. Nevertheless, it would be best if you stayed engaged. After all, it’s yours. Additionally, you’ll have to decide what to do with the shares once they vest.

Dividend

In contrast to stock options, which rarely carry equivalent dividend rights, RSUs typically entitle you to dividends when the share vests. Most companies also pay dividend equivalents for unvested RSUs. If you make a Section 83(b) election at grant, you can change the tax implications and might be able to minimize some tax consequences.

Easy to Comprehend

With RSUs, the event timeline is straightforward to follow. It proceeds like clockwork. Your employer grants RSUs — a non-taxable event. On meeting the agreed conditions, the stock grants vest — a taxable event, and the company deducts some (or all) income tax due. Following that, you will receive shares of stock in your brokerage account equal to the value of these shares at vesting, less any taxes withheld.

The procedure’s simplicity offers clarity regarding when to expect your stock awards. From a financial planning standpoint, knowing when to expect your shares helps you plan a strategy for its value. Whether it is tax or investment planning, you have ample time to make better decisions and develop better strategies.

The benefits of RSUs to the employer are:

Employee Retention

RSUs incentivize employees to stay with a company long term and contribute to its success so that their shares appreciate, maximizing productivity and increasing ROI for the employers and their shareholders.

Lowers Administration Cost

The more shares a company issues, the more resources it spends on tracking and recording those shares. An RSU is a form of a grant or promise to award a share guarantee certain agreed conditions are met. Therefore, it doesn’t necessitate tracking since the company, in essence, hasn’t issued any stock. Employers incur few administrative costs because there are no actual shares to track and record.

Delays Share Dilution

When a company issues additional shares of its stocks, existing shareholders’ percentages of ownership in the company are diluted. Dilution of shares decreases the value of existing shareholders’ stock. While this may improve revenue and profitability long term, it comes with a few disadvantages.

For instance, it increases the risk of loss because there is no guarantee that a new venture will be profitable. It impacts voting and decision-making on important company issues since the existing shareholders’ vote (including the owner) will now weigh less. By deferring issuing of shares until the vesting schedule or other conditions are met, RSUs help employers delay stock dilution as much as possible. Additionally, this process allows the employer to maintain control over the company since no shares mean no vote on important issues.

Gain on Job Termination

Suppose an employee quits the job before the vesting schedule concludes. In that case, they give up their remaining stock to the company. A graded vesting schedule may imply a forfeiture of some part of the stock. However, for a cliff vesting schedule, it means a total forfeiture.

Should Investors Sell Restricted Stock Units?

Upon vesting, employees receive shares of their company stock. A decision to retain or sell the shares may depend on a combination of factors.

Cash-Flow Needs 

If you, the award recipient, are hard-pressed for cash, selling all or parts of the RSUs to meet your financial needs makes sense. It becomes easier if your company is one of those that offer cash options upon vesting.

Company’s Trading Policy

If you work in a public firm, you can sell the company stock immediately after receiving them as long as you comply with your company’s trade policies. For instance, some companies disallow trading stocks at specific times of the year. A private company may necessitate you to wait for a liquidity event (e.g., IPOs, acquisitions or tender offers) before selling. The company may need to approve a sale to a third party. In that case, you’ll have to look for one. Either way, your company’s trading policy may impact your willingness to sell, potentially triggering a change of mind to retain.

Expectations of the Stock’s Future Performance

Suppose your company’s stock has repeatedly performed excellently. In that case, it has the potential for more upward swing, and most people may choose to retain, which might be a great idea. It all depends on your level of risk tolerance. Nevertheless, selling some of it might be the best idea because the market is unpredictable.

Portfolio Diversification 

Financial advisors warn against holding over 10% of your portfolio in a company’s stock. Concentrated stock holdings are fraught with risk. And considering that it is your company’s stock, you’re exposed to two-fold risks if hard times hit the company. One is a potential job loss, and the other is holding worthless stock. As a result, you may prefer to sell all or part of the stock, especially if you want to diversify your portfolio. Tax treatment should also be taken into consideration if you decide to part ways with some of your stock grants.

Taxation

Upon vesting, RSUs create a taxable event with the taxable income determined by the market value of the stock on distribution. Since it’s a compensation income, you’re liable for federal income tax, Social Security and Medicare tax and applicable state and local taxes. It is also subject to compulsory supplemental wage withholding by the employer and appears on Form W-2. You may also be liable to capital gain tax if the share appreciates. A company may provide several options for income tax treatment and capital gains taxes at vesting, or it may use a single mandatory method. Nevertheless, the desire to minimize taxation may push an employee to sell immediately.

Growing RSU Popularity

Equity compensation in the form of RSUs has gained popularity. RSUs offer low-risk equity and clear valuation to employees. Employers benefit from enhanced employee retention, lower administrative costs and control over stock dilution. Employees should consider various factors when deciding whether to sell or retain RSUs, such as cash-flow needs, trading policies, stock performance expectations and portfolio diversification. RSUs serve as an effective tool for retaining top talent and aligning employee interests with company success.

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The post Restricted Stock Units: A Tool for Retaining Top Talent by Chika Uchendu appeared first on Benzinga. Visit Benzinga to get more great content like this.