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
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.
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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
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:
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