Restricted stock units: Meaning, Criticisms & Real-World Uses

What Are Restricted Stock Units?

Restricted stock units (RSUs) represent a promise by an employer to grant an employee shares of the company's common stock or their cash equivalent at a future date, provided certain conditions are met. As a form of equity compensation, RSUs do not confer actual ownership, voting rights, or dividend payments until the restrictions are lifted and the shares are delivered. The primary conditions for RSU vesting typically involve continued employment over a specified vesting schedule or the achievement of specific performance milestones. Once vested, the value of the restricted stock units becomes taxable income for the recipient, and the shares are then typically delivered, giving the employee full ownership.

History and Origin

Restricted stock units gained significant prominence as a form of employee compensation in the early 2000s, largely as an alternative to stock options. Before this shift, stock options were a widely favored incentive, especially in the technology sector, but their appeal diminished following the dot-com bubble burst and major corporate accounting scandals. Many stock options became "underwater," meaning their exercise price was higher than the market price, rendering them worthless.

A pivotal moment in the adoption of restricted stock units occurred in 2003 when Microsoft, a major technology company, announced it would discontinue granting stock options and instead award restricted stock units to its employees. This decision aimed to offer more stable and predictable compensation and to better align employee interests with shareholder value, particularly given the stagnation of its stock price at the time.⁵ This move by a high-profile company influenced many others to re-evaluate their equity compensation strategies. Further driving the trend were changes in accounting standards (such as FASB Statement No. 123R, effective 2006) and tax regulations (like Section 409A of the Internal Revenue Code, enacted in 2004), which altered how companies accounted for and taxed share-based payments, making RSUs more attractive from both an accounting and administrative perspective compared to the traditional stock option model.

Key Takeaways

Restricted stock units are a promise to deliver company shares or their cash equivalent after specific vesting conditions are met, usually related to time or performance.
Unlike traditional stock options, RSUs generally hold value even if the stock price declines, as long as it remains above zero.
The fair market value of restricted stock units at vesting is treated as ordinary income and is subject to income tax.
RSUs help align employee incentives with the long-term success of the company, as employees benefit directly from increases in the company's stock price.
Companies often use restricted stock units as a tool for talent attraction and retention without immediate cash outlay.

Formula and Calculation

While there isn't a complex financial formula to calculate the grant value of restricted stock units (as their value is directly tied to the underlying stock price), the calculation primarily relates to the number of shares received upon vesting and the resulting taxable income.

The value of the RSU grant at vesting is calculated as:

\text{Value at Vesting} = \text{Number of Vested RSUs} \times \text{Fair Market Value per Share at Vesting}

This "Value at Vesting" is considered ordinary income and is typically subject to federal, state, local, and payroll taxes. Companies often withhold a portion of the vested shares to cover these tax obligations.

For example, if an employee is granted 1,000 restricted stock units that vest, and the fair market value of the company's stock on the vesting date is $50 per share, the total value recognized as ordinary income is:

1,000 \text{ RSUs} \times \$50/\text{share} = \$50,000

A portion of this $50,000 will be withheld for taxes, and the employee will receive the net number of shares or their cash equivalent.

Interpreting Restricted Stock Units

The value and implications of restricted stock units are primarily interpreted based on two key factors: the company's stock performance and the employee's vesting schedule. For employees, RSUs represent a deferred compensation benefit, with the actual payout directly tied to the company's share price at the time of vesting. This direct correlation means that as the company's valuation increases, so does the potential value of the restricted stock units.⁴

From a corporate governance perspective, RSUs are viewed as a tool to align the interests of employees with those of shareholders. By granting future equity, companies incentivize employees to contribute to long-term growth and profitability, as their personal financial gain is linked to the company's stock price appreciation. The structured vesting schedule also acts as a retention mechanism, encouraging employees to remain with the company through the vesting period.

Hypothetical Example

Consider an employee, Sarah, who joins Tech Innovators Inc. on January 1, 2024. As part of her compensation package, she is granted 4,000 restricted stock units with a four-year graded vesting schedule, meaning 25% of the RSUs vest each year on the anniversary of her grant date. The fair market value of Tech Innovators Inc. stock on the grant date is $25 per share.

January 1, 2025 (Year 1 Vesting): 1,000 RSUs (25% of 4,000) vest. The stock price on this date is $30 per share.
- Sarah's taxable income from this vesting event is 1,000 shares * $30/share = $30,000.
- Tech Innovators Inc. withholds a portion of these shares (e.g., to cover federal income tax, Social Security, and Medicare taxes) and delivers the net shares to Sarah.
January 1, 2026 (Year 2 Vesting): Another 1,000 RSUs vest. The stock price is now $35 per share.
- Sarah's taxable income is 1,000 shares * $35/share = $35,000.
January 1, 2027 (Year 3 Vesting): Another 1,000 RSUs vest. The stock price is $40 per share.
- Sarah's taxable income is 1,000 shares * $40/share = $40,000.
January 1, 2028 (Year 4 Vesting): The final 1,000 RSUs vest. The stock price is $45 per share.
- Sarah's taxable income is 1,000 shares * $45/share = $45,000.

After each vesting event, Sarah receives actual shares that she can choose to hold or sell. If she holds the shares and their value increases further, any subsequent profit when she sells them will be subject to capital gains tax.

Practical Applications

Restricted stock units are widely used in various facets of the financial world, particularly within human resources, corporate finance, and financial planning.

Employee Compensation and Retention: RSUs are a staple in equity compensation packages across industries, especially in technology and high-growth sectors. They are favored for attracting and retaining top talent, as the future value of the award encourages long-term commitment.
Startup and Pre-IPO Companies: For private companies, especially those nearing an initial public offering (IPO), RSUs are a common mechanism to offer employees a stake in the company's future without granting immediate stock ownership or creating an illiquid market for shares. The shares typically vest upon a liquidity event, such as an IPO or acquisition. The U.S. Securities and Exchange Commission (SEC) has provided specific exemptions that allow non-public companies to grant RSUs without immediate registration requirements, which is crucial for managing their employee equity programs.³
Accounting and Financial Reporting: Companies must account for restricted stock units as a compensation expense on their income statement over the vesting period. This expensing reflects the cost of employee services received in exchange for the equity award. Accurate accounting for RSUs is essential for compliance with financial reporting standards and for providing transparent information to shareholders and potential investors.²
Taxation: For employees, RSUs are treated as ordinary income upon vesting, based on the fair market value of the shares at that time. Companies typically handle the tax withholding by selling a portion of the vested shares ("sell-to-cover") or by requiring the employee to pay the tax liability in cash. Understanding these tax implications is a critical component of personal financial planning for employees receiving RSUs.

Limitations and Criticisms

Despite their popularity, restricted stock units have certain limitations and face criticisms, primarily concerning their impact on both employees and the issuing company.

One significant drawback for employees is the risk of overconcentration in company stock. As restricted stock units vest, employees accumulate shares of their employer's stock. Without a proactive strategy to diversify, a substantial portion of an individual's net worth can become tied to a single company's performance. This creates an uncompensated risk, as both employment income and investment wealth depend on the same entity. Should the company's stock price decline significantly, or if the company faces financial distress, employees risk substantial financial loss to both their compensation and investment portfolio.¹

From the company's perspective, RSUs can lead to dilution of existing shareholder ownership. When restricted stock units vest and new shares are issued, it increases the total number of outstanding shares, which can dilute the ownership percentage and earnings per share for existing shareholders. While the issuance of RSUs is recognized as a non-cash compensation expense, it still represents a cost to the company and its equity.

Additionally, the forfeiture risk for employees is a notable limitation. If an employee leaves the company before their restricted stock units vest, they typically forfeit all unvested awards. While this serves as a powerful retention tool, it can also limit employee mobility and potentially lead to dissatisfaction if an employee feels "locked in" due to substantial unvested equity. Another criticism is that while RSUs align employee interests with stock price appreciation, they may not always incentivize truly exceptional performance beyond what is required to remain employed and vest. For instance, RSUs do not offer the same leverage as deeply "in-the-money" stock options might, which could motivate extreme efforts to drive up stock prices.

Restricted Stock Units vs. Stock Options

Restricted stock units and stock options are both forms of equity compensation designed to align employee interests with company performance, but they differ significantly in their mechanics, value, and tax treatment.

Feature	Restricted Stock Units (RSUs)	Stock Options
Nature of Grant	A promise to deliver shares or cash equivalent upon vesting.	The right, but not the obligation, to purchase company shares at a predetermined "strike price" within a specified period.
Immediate Value	Generally always have some value upon vesting (unless stock goes to $0).	Can become "underwater" (worthless) if the market price falls below the strike price. Only have value if the market price exceeds the strike price.
Cost to Employee	No direct cost; shares are delivered upon vesting.	Employee must pay the strike price to "exercise" the option and acquire the shares.
Vesting	Shares are delivered once vesting conditions (time or performance) are met.	The option to purchase becomes exercisable once vesting conditions are met.
Taxation	Fair market value at vesting is taxed as ordinary taxable income.	Non-qualified stock options (NQSOs) are taxed as ordinary income on the "bargain element" (difference between market price and strike price) at exercise. Incentive stock options (ISOs) have more complex tax rules, often involving alternative minimum tax (AMT).
Shareholder Rights	No voting rights or dividends until shares are vested and delivered.	No voting rights or dividends until options are exercised and shares are acquired.
Purpose	Employee retention, aligned long-term value.	Incentive for significant stock price appreciation; can provide greater leverage if stock price rises substantially.

The primary confusion often arises because both link an employee's wealth to the company's stock. However, RSUs generally provide a more guaranteed payout (assuming the company's stock retains any value), whereas stock options offer a higher potential upside but also the risk of being completely worthless if the stock performs poorly relative to the strike price. RSUs have become particularly popular due to their simpler accounting and taxation for companies and their more predictable value for employees compared to stock options.

FAQs

What happens when restricted stock units vest?

When restricted stock units vest, the restrictions are lifted, and you gain full ownership of the underlying company shares. At this point, the fair market value of the shares is considered ordinary taxable income and is subject to income and payroll taxes. Your employer typically withholds a portion of the shares to cover these taxes, and you receive the remaining net shares, which you can then hold or sell.

Are restricted stock units taxed?

Yes, restricted stock units are taxed. Upon vesting, the full fair market value of the shares is included in your ordinary income for that year. This amount is subject to federal, state, and local income taxes, as well as Social Security and Medicare taxes. If you hold the shares after vesting and later sell them for a profit, that profit will be subject to capital gains tax (either short-term or long-term, depending on your holding period after vesting).

Can I sell restricted stock units before they vest?

No, you cannot sell restricted stock units before they vest. They are "restricted" because you do not have actual ownership or control over the shares until the vesting schedule conditions are met. Until vesting occurs, RSUs are essentially a promise of future shares.

Do restricted stock units receive dividends?

Typically, no. Restricted stock units generally do not receive actual dividend payments or voting rights until they have vested and the shares have been delivered to you. However, some RSU plans may include "dividend equivalents," where you receive a cash payment equal to the dividends that would have been paid on the unvested RSUs had they been actual shares. This payment is usually made at the time of vesting.

Why do companies use restricted stock units?

Companies use restricted stock units primarily to attract, retain, and incentivize employees. RSUs align employee interests with the long-term success of the company without requiring employees to purchase shares (as with stock options). They provide a tangible value, even if the stock price does not significantly appreciate, making them an effective retention tool. From an accounting perspective, RSUs also offer a more predictable expense recognition compared to some other equity compensation vehicles.