Does your startup want to attract top talent while driving performance? Startup stock options are a popular method by which companies accomplish these goals. While there are many options available, RSU stocks are an excellent choice.
Keep reading this article to learn everything you need to know about RSU stocks.
What Is RSU Stock?
RSU stocks, or restricted stock units, are a promise to deliver common stocks at a future time. There are contingencies for RSU stock compensation and shares, such as performance and vesting schedule requirements, which make it “restricted.” The recipient doesn’t receive RSU stocks until the term limit lapses.
Vesting is how an individual earns RSU stocks. It allows startups to incentivize employees to perform better while retaining key performers longer. Also, the employee doesn’t need to purchase RSU stocks since they are granted at no upfront cost. It is important to note, however, that employees have to pay income tax on RSU stocks when they vest.
Here’s an article about RSU stocks.
How Does RSU Stock Work?
RSU stocks gives employees skin in the game, similar to employee stock options, but instead of the employee needing to purchase the options, the RSU stock’s ownership is transferred to the employee once vested. It’s a benefit that gives them an economic interest over the company’s operations. Companies provide the employee with a specific number of incentive stock options.
Not Immediately Available
Keep in mind that the ownership of RSU stock is not immediately transferred to the employee. Instead, the employee is given a time by which they have to meet a goal by a specific date. Upon completing satisfactory requirements, the company transfers ownership of the RSU stock to the employee, thereby granting a vested interest.
Fair Market Value Vestments
During the grant, the RSU is assigned a fair market value (FMV). The FMV is done, typically through a 409A valuation, which means the employee is given a fair value at the time it is granted. In general, RSU stocks don’t pay dividends until converted to common stocks.
Vesting Schedules
Vesting schedules require employees to work at a startup for a specific period before vesting occurs. Startups can use a grading method where they place restrictions on stocks that happen over a three-to-five-year period. New IPO companies may also utilize grants during a liquidity event before the IPO and shares vest.
The termination of an employee always halts the vesting process unless otherwise previously agreed upon. The only exception to this rule is when a situation arises that allows accelerated vesting, including disability, death, and retirement.
Example of How RSU Stocks Work
Shares of RSU stocks are generally received by the employee as common stocks following the vesting date, although there may be some delay between the vesting and the delivery of the stocks. It’s at this point that the employee will have rights like a normal common stock holder, like dividends (rare in startups) and voting.
Below is an example of how RSU stocks work:
- Tom is an employee at ABC Company Inc.
- ABC Company Inc. grants 1,000 RSUs at an FMV of $25
- The value at the time of granting RSUs is $25,000
- After three years, the RSUs become vested at an FMV of $30
- The value of the RSUs at the time of vestment is $30,000
As you can see, RSU stocks are an excellent choice when encouraging key employees to meet performance or time goals. Not only do startup employees have the potential to become a shareholder, but they can also earn more money based on performance. This approach also results in departments becoming more concerned about the overall performance of individual teams.
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RSU Stock vs. Stock Options
RSU stocks and stock options are both used to incentivize employee performance. However, there are a few key differences, including value levels and treatment of taxes. Both types require different strategies, which means you should speak with startup lawyers for advice.
What Are Stock Options?
Stock options offer the holder buying and selling rights on specific shares. They’re commonly used by investors and businesses to incentivize employees to achieve maximum job performance. Employees must also remain at the company long enough to receive proceeds.
Key Differences Between RSUs and Stock Options
While RSUs and stock options may appear the same, there are fundamental deviations away from the two. Here’s a general overview of the key differences between RSU stocks and stock options as described below:
Difference 1: Value Levels
Stock options could become worthless if the FMV is below the initial price. This result is due to no one wanting to pay more than the market price for shares. In contrast, RSU stocks retain value since they’re distributed as shares versus purchased, like stock options.
Difference 2. Treatment of Taxes
RSU tax is treated differently from stock options. You’re taxed when receiving RSU-associated shares. Taxable amounts are based upon FMV at the time of shares are granted.
Gains on RSU stocks are taxed at the capital gains tax rate. In contrast, two types of stock options exist and are taxed differently from one another.
The two types of stock options and taxation guidelines are as follows:
- Type 1. Incentive stock options (ISOs) : Not necessarily taxed. Any sale gains are taxed using short or longer-term capital gains rates determined by the share’s holding period before the sale.
- Type 2. Non-qualified stock options : The difference between the price and market value of the stock options are counted as ordinary income. Therefore, non-qualified stock options are subject to payroll taxes also.
Difference 3. Motivation
Employees take ownership of their roles when they have the prospect of earning RSUs. Upon the vestment of the stock, employees automatically become partial owners of the startup. They will have voting rights and the ability to earn dividends, which makes them more focused on achieving strategic company goals.
Stock options often result in employees concentrating on short-term gains versus long-term strategies. There’s nothing wrong with offering this option if you need to achieve short-term goals. However, you may want to leverage RSU stocks if your startup wants to drive long-term growth.
Should a Startup Use RSU Stocks or Stock Options?
Determining whether to offer RSU stocks vs. stock options depends upon your startup’s specific situation. The employee may earn more by taking stop options if the shares are purchased at a below-market price. On the other hand, RSU stocks typically retain value.
This article also explains RSU stocks vs. stock options.
Do RSU Stock Get Taxed Twice?
RSU stocks don’t get taxed twice. However, they are taxed differently from ordinary stock options. Stock options are generally taxed at the sale, while RSU stocks are only taxable after the vesting schedule resolves.
How RSUs Get Taxed
Due to a more simple taxation method on RSU stocks, they are a bit more straightforward regarding employee stock plans. Since there’s no stock issuance when granting them, they don’t have to worry about Section 83(b) elections that apply to stock options.
There’s a single date by which the stock’s value can be declared. Reported amounts are equal to FMV on the vesting date. As such, stock values are reported as ordinary income during the tax year in which the stock becomes vested.
Get Legal Help with RSU Stocks
The tax rules and legal strategies associated with RSU stocks may differ by startup. They are also very complicated, which means that the wrong approach could potentially yield unwanted legal and financial consequences. Ensure that you structure your employee benefits carefully to avoid this situation.
As such, you should always speak with startup lawyers for advice and guidance. Post a project for free on ContractsCounsel to set up a consultation.
