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Restricted Stock Awards (RSA) and Restricted Stock Units (RSU) are two popular options of equity compensation. Are they the same? Between RSA and RSU, the difference is more than the letters A and U.
In this article, we’ll explore how restricted stock works, the key differences between RSA and RSU, their characteristics, tax treatment (capital gains and ordinary income tax), and vesting schedules.
Overview of Restricted Stock Awards
Restricted Stock Awards (RSAs) are a type of equity compensation that companies grant to employees as a form of ownership in the company. Under an RSA, employees receive shares of the company’s stock on the grant date subject to specific restrictions and conditions. Let's dive deeper into the definition, characteristics, and vesting schedule associated with RSA.
What is RSA?
Restricted Stock Awards (RSAs) are grants of company stock given to employees with certain restrictions or conditions attached to them. These awards serve as a way for companies to provide employees with a tangible stake in the organization's success and align their interests with those of the company's shareholders.
When employees receive RSA on the grant date, they receive a specified number of restricted shares or units of the company's stock. These units may carry voting rights, allowing employees to participate in certain corporate decisions. Additionally, employees may be eligible to receive dividends on the restricted stocks if the company declares and pays dividends during the vesting period.
RSA grants typically come with a vesting schedule that outlines the conditions an employee must meet to gain full ownership of the unvested RSA shares. The vesting schedule specifies the time-based or milestone-based requirements an employee must fulfill to become fully vested in the RSA shares.
Time-based vesting plans often span several years, with shares vesting incrementally over time. Milestone-based vesting may be tied to achieving performance milestones, targets, or goals.
Throughout the vesting periods or period, employees may need to remain employed by the company and fulfill any additional requirements outlined in the RSA agreement. Once the vesting conditions are met, employees gain complete ownership of the vested shares, allowing them to sell, transfer, or retain the stock as they see fit.
Pros and Cons of RSA
Restricted Stock Awards (RSA) offer several advantages and considerations for both employees and employers. Let's explore the pros and cons of RSA, including taxation benefits, employee motivation, and administrative complexity.
Taxation Benefits
One significant advantage of RSA is the favorable tax treatment it provides to employees. When RSA shares vest, employees generally owe ordinary income tax upfront based on the fair market value of the stock at that time.
However, employees can opt to pay ordinary income tax at the time of grant to ensure that any future appreciation in the stock's value is subject to the lower capital gains tax rate. This can be done by making an 83 (b) election.
The 83 (b) election is a provision in the US tax code that allows individuals with restricted stock to include the value of the awarded stock in their income at the time of grant instead of at vesting. Normally, individuals must include the value of their restricted stocks in the income at the time of vesting, which might be a different tax year from when the shares were granted.
There are advantages and disadvantages to making an 83 (b) election. The biggest advantage lies in lower tax liabilities.
If the stock value appreciates between the award date and the vesting date, including the lower award date value in the income by making an 83 (b) election can result in a lower tax liability. It also starts the clock for the holding period required to qualify for long-term capital gains treatment, potentially leading to lower tax rates upon future sale.
When employees pay taxes like ordinary income tax upfront with an 83 (b) election, they can potentially benefit from a bigger taxable gain if they choose to sell the vested shares at a later date.
On the other hand, employees making an 83(b) election take on the risk of including the value of the stock in their income even if the stock never vests or they end up forfeiting the unvested shares.
Employee Motivation
RSA can be a powerful tool to motivate and incentivize employees. By granting ownership in the form of restricted
stock, employees feel a sense of ownership and are more likely to be invested in the company's success.
RSA aligns their interests with that of the company's shareholders, fostering a stronger commitment to achieving organizational goals. Employees who have a stake in the company's performance are often more motivated, engaged, and likely to go the extra mile to contribute to its success.
Administrative Complexity
On the other hand, while RSA offers numerous advantages, it can also introduce administrative complexity for employers. Companies must establish processes to manage RSA grants, including tracking vesting times, calculating fair market value, and ensuring compliance with tax regulations.
Administrative tasks related to RSA can be time-consuming and require specialized knowledge to accurately handle tax reporting, withholding requirements, and communication with employees about the value and taxation of their awards. Employers need to dedicate resources to properly administer RSA and educate employees about its implications.
Despite the administrative complexities, RSA remains an attractive equity compensation option for employers, particularly in certain scenarios. Early-stage startups, for instance, can utilize RSA to attract top talent by offering an ownership stake in the company's future success.
RSA can also be beneficial for retention-focused organizations that aim to incentivize employees to stay with the company long-term, as the vesting schedule encourages loyalty and commitment.
Best Scenarios to Use Restricted Stock Award
Restricted Stock Awards (RSA) can be particularly beneficial in certain scenarios, making them a preferred choice for early-stage startups and retention-focused organizations. Let's explore why these contexts are well-suited for RSA implementation.
Early-Stage Startups
For early-stage startups, RSA serves as a valuable tool to attract and retain top talent. Since startups often face financial constraints and may not be able to offer competitive salaries, granting RSA allows them to offer an ownership stake in the company's future success.
Employees become motivated to contribute to the company's success as they have a direct stake in its performance. Additionally, the upfront tax payment associated with RSA enables employees to pay capital gains tax at a potentially lower rate in the future.
Retention-Focused Organizations
Retention-focused organizations can also utilize RSA as part of their comprehensive employee retention strategy. By implementing RSA, private companies create a vested interest for employees to stay with the organization over the long term.
The vesting schedule of RSA ensures that employees receive the full value of their awards only after a specific period, incentivizing loyalty and commitment. Employees are more likely to remain with the company to unlock the full benefits of their RSA grants, reducing turnover rates and fostering stability within the organization.
Overview of Restricted Stock Units (RSU)
Restricted Stock Units (RSUs) have gained popularity as an equity compensation tool, offering unique benefits for both employers and employees. How do they differ from RSAs?
What is RSU?
Restricted Stock Units (RSUs) represent a promise to deliver a specific number of company shares to an employee at a future date, provided that the employee meets the vesting conditions. Unlike actual shares, RSUs are not granted upfront but instead represent a contractual right to receive the equivalent value in company stock. RSUs provide employees with a stake in the company's success and performance.
RSUs possess distinct characteristics that set them apart from other forms of non-cash compensation. When RSUs are granted, employees do not have immediate ownership or voting rights.
Instead, they have a contingent right to receive the company shares upon meeting specific vesting conditions. The value of RSUs is typically tied to the fair market value of the company's stock at the grant date.
RSUs are subject to a vesting schedule, which determines when the company shares are fully owned by the employee. The vesting period is typically based on time, often spanning multiple years, during which the employee must remain with the company to become eligible for the shares.
Once the vesting conditions are satisfied, the RSUs "vest," and the employee receives the shares or their equivalent value. The vesting schedule can vary, with some companies implementing cliff vesting (where shares fully vest after a specified period) or graded vesting (where shares vest incrementally over time).
Pros and Cons of Restricted Stock Unit
Similar to RSA, Restricted Stock Units (RSU) offer distinct advantages and considerations for both employees and employers. Let's explore the pros and cons of RSU.
Tax Advantages for Employees
Unlike in RSA, restricted stocks from RSU are not eligible for an 83 (b) election. Since unvested shares do not have an actual value or ownership rights at the grant date, there is no income to report for tax purposes until the RSUs vest and are settled.
However, RSU provides tax advantages for employees by deferring tax obligations until the shares vest. When RSU shares vest, employees must pay ordinary income tax based on the fair market value of the stock at that time.
However, the potential capital gains tax is deferred until the employee decides to sell the vested shares. This deferral can result in tax savings if the employee holds the shares for an extended period, as any future appreciation in value may be subject to the lower capital gains tax rate.
Lower Risk Compared to Stock Options
One significant benefit of RSU is that it carries lower risk compared to stock options. With stock options, employees have the right but not the obligation to purchase shares of company stock at a specific price, known as the exercise price. If the stock price declines, employees may choose not to exercise their options, avoiding potential losses.
In contrast, RSU guarantees employees a specific number of the company’s stock once they vest, regardless of the stock price. This eliminates the risk associated with the stock's performance and provides employees with tangible value.
Dilution Concerns
One potential drawback of RSU is dilution. When a company grants RSUs to employees, it increases the total number of outstanding unvested shares, which dilutes the ownership percentage of existing shareholders.
This dilution can be a concern for current shareholders, as it reduces their proportional ownership and potential earnings per share. Employers must carefully manage the number of RSUs granted to maintain a balance between employee incentives and the interests of existing shareholders.
Best Scenarios to Use RSU
Restricted stock units are particularly suitable for later-stage startups and companies seeking flexibility in equity compensation. As companies mature, RSU becomes a popular choice because it provides employees with a clear and valuable ownership stake without the complexities associated with stock options.
Later-Stage Startups
For established startups that have progressed beyond the early stages, RSUs can be a valuable tool to attract and retain top talent. As companies grow and secure additional funding, RSUs offer employees a tangible stake in the company's future success.
RSUs provide an opportunity for employees to benefit from the appreciation in the company's stock value without requiring an upfront financial investment. This can be especially appealing to candidates considering joining a later-stage startup, as they see the potential for significant financial rewards as the company continues to thrive.
Flexibility in Equity Compensation
Companies that value flexibility in their equity compensation plans often opt for RSUs. RSUs provide greater control over the timing and distribution of equity grants compared to other forms of non-cash compensation, such as stock options.
RSUs can be structured with specific vesting plans and conditions tailored to meet the company's goals and objectives. This flexibility allows companies to incentivize employees based on performance milestones, ensuring that rewards are tied to the achievement of predetermined targets. Additionally, RSUs can be structured to align with the company's overall compensation strategy, providing a well-rounded package that combines base salary, benefits, and equity.
Comparing RSA vs RSU
To better understand the differences between RSAs and RSUs, let's compare them side by side:
Restricted Stock Award (RSA)
- Definition: Employees receive units that are subject to specific restrictions
- Characteristics: Tangible ownership, shareholder voting rights
- Vesting Schedule: Typically time-based or achievement of performance milestones
- Tax Implications: On the grant date, value of awarded shares is subject to ordinary income tax via 83 (b) election; any future appreciation is subject to capital gains tax
Restricted Stock Unit (RSU)
- Definition: Employees receive company stock represent a promise to deliver company stock
- Characteristics: No immediate ownership, no shareholder voting rights
- Vesting Schedule: Typically time-based or achievement of performance milestones
- Tax Implications: Upon vesting, fair market value of shares is subject to ordinary income tax; any future appreciation is subject to capital gains tax
Both RSAs and RSUs have vesting plans that follow time-based or performance milestone-based schedules. This ensures employees meet specific conditions before the stocks become fully vested.
One key distinction between RSAs and RSUs lies in the nature of ownership and voting rights. RSA grants tangible ownership, allowing employees to participate in voting decisions and benefit from dividends. Restricted Stock Units, however, do not offer immediate ownership or voting rights.
Another significant difference lies in the timing of taxation. Both may be subject to ordinary income tax and capital gains tax, but RSAs trigger taxation on the grant date while RSUs trigger taxation upon vesting.
Factors to Consider when Choosing RSA vs RSU
Several factors come into play when deciding between RSAs and RSUs. Employers and business owners need to consider the implications implicit in paying taxes, for both employees and the company, vesting plans and requirements, employee retention goals, and the financial stability of the company.
Tax Implications
Both RSA and RSU have distinct tax implications for employers and employees. Employers should carefully evaluate the tax treatment of each option and consider how it aligns with their compensation strategy.
Employees need to understand the tax implications associated with receiving RSA or RSU and evaluate the impact on their financial situation. Factors such as capital gains tax rates, upfront payment of ordinary income tax, and possible taxable gain should be considered when making a decision.
Vesting Schedules and Requirements
The vesting schedule and requirements differ between RSA and RSU. Employers must analyze their specific needs and consider the impact of each structure on employee retention and motivation.
RSA typically involves time-based or performance-based vesting plans, while RSU often follows a time-based vesting schedule. Companies should align their equity compensation strategy with their retention goals and choose the structure that best supports those objectives.
Employee Retention Goals
Retaining talented employees is crucial for a company's success. When deciding between RSA and RSU, employers should consider the impact of each on employee retention. RSA, with its potential tax advantages and longer vesting periods, can be an effective tool for encouraging long-term commitment. On the other hand, RSU, with its simpler structure and shorter vesting periods, may be more suitable for companies seeking flexibility and agility in their equity remuneration plans.
Financial Stability of the Company
The financial stability and stage of the company should also be considered when choosing between RSA and RSU. Early-stage startups or private companies may find RSA more attractive as it allows them to grant ownership while managing the potential tax burden effectively. Public companies or those planning for a liquidation event may prefer RSU due to its simplicity and marketability.
By carefully evaluating these factors, companies can make an informed decision regarding the use of RSA vs RSU in their compensation package. It's essential to weigh the tax implications like ordinary income tax, vesting schedules, employee retention goals, and financial stability to choose the structure that aligns with the company's objectives and employee needs. Consulting with professionals experienced in equity compensation can provide valuable insights and guidance throughout the decision-making process.
Remember, each company's circumstances are unique, and what works well for one organization may not be the best fit for another. Careful consideration of these factors will help ensure that the chosen equity plan structure aligns with the company's goals and maximizes the benefits for both employers and employees.
Conclusion
In summary, RSA and RSU are distinct equity compensation tools with their own advantages and considerations. Employers and business owners must carefully evaluate their company's needs, employee expectations, and financial circumstances when choosing between RSA vs RSU. Consulting with legal and financial professionals can provide invaluable guidance to navigate the complexities of equity compensation and ensure alignment with both employer and employee interests.
At Upstock, we guide and empower businesses by making equity plan management easier, more accessible, and more effective. Still unsure whether to get RSA or RSU? Drop us a message for a consultation today!
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