Restricted Stock Units (RSUs), Downside Protection with a Couple Downsides

Equity Compensation – Restricted Stock Units (RSUs), Downside Protection with a Couple Downsides

Equity Compensation – Restricted Stock Units (RSUs), Downside Protection with a Couple Downsides

03/07/2013

Stickman - equity compensation - rsu
Dan Walter, Performensation

Last month I covered Restricted Stock Shares (RSS), today’s post covers Restricted Stock Units (RSUs). Where RSS and Stock Options are cousins, RSS and RSUs are siblings. RSS is the older sibling, with more years and experience under its belt. RSUs are the new little sister who came by surprise and often gets more attention than seems to be required. RSUs were seldom used before they shot into the spotlight following the Dotcom crash of 1999-2000. Initially, they were used to replace underwater stock options and slow the use of plan shares approved by shareholders. They provided some protection against a decrease in stock price and used somewhere between 25-50% of the shares require to provide the same value as stock options. They quickly became a major component of the equity compensation toolbox.

RSUs are generally “full value” awards, meaning that they have no purchase or exercise cost to the participant. Unlike RSS, RSUs do not require the issuance of real shares until the units are vested. This is why they are called “units” rather than shares. Many companies use the term “Award” to refer to RSUs, RSS and any other full value instrument. This separates them from the “grant” of appreciation-only instruments like ISOs, NQSOs and SARs. Either term can be used interchangeably. RSUs live in the interesting middle ground between real restricted stock and stock options to purchase shares in the future.

It is also important to note that although the majority of RSUs are designed to settle in stock, these awards can also be designed to allow, or require, settlement in cash. Cash settlement has the upside of not diluting other shareholders’ ownership position and the downside of requiring variable accounting.

As general rule, participants do not have any income from RSUs at the time of award. The ordinary income event occurs when the units vest and shares are delivered. At the time of vest the company is obligated to withhold income and employment taxes for eligible employees.

RSUs fall under IRC 409A, the deferred income and taxation rules. Even private companies need to have a reasonable basis for the value of their stock if they wish to use these awards. It also means that one of the key potential benefits of RSUs, the elective deferral of income, is subject to restrictions that make the process onerous for both participants and companies. Because of this, many companies no longer allow participants to make deferral elections. Another downside: Unlike RSS, participants can’t file an 83(b) election to accelerate income to a time when the spread is very low. Unlike Stock Options, participants do not get to elect when, in the future, the income and tax event takes place. This lack of income and tax planning flexibility is important.

In spite of the downsides, RSUs are a great tool. Because they do not require the immediate issuance of stock, companies can avoid creating instant shareholders and paying ongoing dividends. If the individual leaves with unvested units, the company can easily cancel them rather than go through the process of forfeiture and repurchase. They are an excellent retention tool in companies with an ownership culture and can provide a simple way to provide equity to broad-based participants around the world (we will cover international aspects in a later post).

Like any equity compensation tool RSUs, do not work perfectly as the “only” equity compensation tool for any company. As we explore this equity compensation series the first Thursday of every month we will discuss other tools and way these tools can be used together to provide a complete solution to your company’s needs.

Edited Thu, Oct 17, 2013 4:32 PM

Replies to this Topic

Dan:

If we assume that the purpose of equity grants is a) to align the grantee's interests with the shareholders and b) preserve and increase company cash, Employee Stock Options should be the best choice for the company.

Why? Because, with ESOs, the grantee  will gain nothing unless the stock increases and the alignment can continue past vesting for as long as 10 years from grant. Company cash is preserved and cash is increased when the grantee exercises.

On the other hand, RSUs pay to the grantee even if the stock goes down so the alignment is limited. And RSUs reduce cash from the company when vesting takes place. With RSUs the alignment ends at vesting. Yes, there is no dilution with RSUs.

Certainly ESOs are not perfect. And often the grantee eliminates alignment at vesting by early exercise, sell and diversify if the stock is trading substantially above the exercise price. The ESO contract can be modified to make it such that alignment is longer, cash flow comes early to the company, the grantee can better manage risk and even the wealth managers get AUM quicker. Check out how it is done on the link below:

 

http://www.slideshare.net/OLAslideshare/screen-recording-108

 

John Olagues

Hi John,

It is very shortsighted to "assume that the purpose of equity grants is a) to align the grantee's interests with the shareholders and b) preserve and increase company cash" at every company and for every employee.

Company now use equity compensation for a wide range of other reasons.


 

Dan:

 

You certainly have more experience and knowledge than I do regarding why companies issue equity compensation like RSU, Restricted stock, ESOs, SARs etc.

What would you say are the main motivation factors that influence the grants of equity compensation in general and ESOs or RSUs in particular?

 

John

I'd just like to point out that a lot of systems/providers use the term Restricted Stock Awards (RSA) for what Dan calls RSS in the post above.

And though I, personally, am a big fan of RSUs as opposed to RSAs, mainly for taxation reasons, another downside is that they are subject to the tax deductibility limit of $1 million imposed by 162(m). RSS/RSAs are exempted from that limit.

Thanks for the additions Elizabeth.

 

John:  Great question.  I will put together a response very soon.

 

Dan

 

Reply:

olagues@gmail.com

 

Here is an article which is merely a few quotations of experts in the Finance arena but which address somewhat why equity compensation is granted.

March 22, 2013


For Holders and Advisers of Employee Stock

Options:

 
This article shows the views of several authorities

on Employee Stock Options, using their Quotations.

Quotations from authorities on Employee Stock

Options

 

 Traditional "employee stock options were poorly

 structured, and, consequently, they failed to

 properly "align" the long-term interests of shareholders

 and managers, the paradigm so essential for effective

 corporate governance."

Alan Greenspan

 

"Traditionally, stock option plans have been used as

a way for companies to reward top management and

"key" employees and link (i.e. align) their interests

with those of the company and other shareholders."

"Options are a great way to preserve cash while giving

 employees a piece of future growth."

NCEO website

 

 

 

"Moreover, for many firms, the proceeds

 (and associated tax benefits) from options

exercises have grown to become one of the

largest items on the cash flow statement.

Nevertheless, despite the substantial magnitude

of these cash-flows, the extent to which they

affect firm investment and financing policies

has received little attention in academic literature. "

Ilona Babenko Ph.D. Arizona State Assistant

Professor

 

 

"Hi John,

This article that you wrote on the Fiduciary Duties

 to manage risks by selling calls and buying puts is

great. It is really shocking that advisers are

not encouraging hedging strategies for ESOs.

Even without the ESO exposure, employees have

such concentrated positions by virtue of their salary

being tied to the success of their firms. Once you add

ESOs, the risk to an employee can be staggering,

particularly as they age and the likelihood of finding

alternative employment drops."

 

Ed Szado Ph.D. University of Massachusetts,

Director of Research INGARM, http://www.ingarm.org/public/management

I hope you enjoy this as it illustrates that are many

aspects of employee stock options that are seldom

discussed.

Sincerely,

John Olagues

504-875-4825

olagues@gmail.com

John

To your points:

  1. In the financial services sector (in particular), employers reduce / defer cash compensation of 75 - 100% of the initial value of RSUs.  In this way, the employee is effectively paying for the RSUs on a pre-tax basis on award date.
  2. RSUs generally have the capacity (at the employer's direction) to be stock-settled (1 RSU equals 1 share), and any employers use this facility where they are able to.  In this way, employees can continue to be aligned to shareholders post-vesting. 

I understand that there are also accounting advantages to RSUs relative to options because the employer needs to subject less share (equivalents) to award.  Having said that, like RSSs, the tax liability on RSus generally arises on vesting date so there is in effect a "forced exercise" at a time when an employee has no control, which is less satisfactory for the employee than an option from a wealth creation perspective.

Dan presents a good short summary of some of the pros/cons of RSUs.

It does mention that with RSUs "the elective deferral of income, is subject to restrictions that make the process onerous for both participants and companies. Because of this, many companies no longer allow participants to make deferral elections." This is one aspect of RSUs that may change in the future with higher tax rates. I expect to see the deferral election getting more attention as a feature to add, as it allows deferring taxes to the future when shares delivered.  

For more on the topic of share deferral with RSUs see: http://bit.ly/15PfhUh

Dan's article does a good job of describing the three limitations regarding receiving Restricted Stock Units.  The following link contains ideas to help RSU recipients get the most out of them:  

http://tinyurl.com/cahm6aa
 

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