While stock options remain a popular and widely used form of equity compensation, the time when they dominated the employee incentive scene has long since passed.
Over the last several years, companies have increasingly turned to other forms of stock grants in the ongoing mission to attract and retain key talent and encourage high performance in the workplace.
There are many reasons why companies have broadened their approach on this front, not least of which being accounting rule changes introduced in 2005 that required companies to thereafter treat stock options as expenses, thus increasing the costs associated with the process of awarding options and making many businesses more selective about doing so.
Also, stock options in private companies tend to lose some of their appeal when the business grows beyond a certain level. Fair market value (FMV) rules will limit a company’s ability to offer meaningful discounts in connection with options without risking negative tax implications. So, a high company valuation will be reflected in the exercise price, meaning employees pay more to turn their options into stock.
And when high value private companies move towards going public – as most will do – the exercise price at that point will be linked to the initial flotation price, further limiting the prospect of a windfall for new hires. It’s not that it’s impossible for later hires to make a substantial profit, but it becomes less likely. Earlier hires usually fare noticeably better, as they will have paid less to exercise their options.
Against this backdrop, while share options undoubtedly still have their place, increasing numbers of businesses have been looking at alternative equity grants when considering their own compensation strategies. As with all forms of equity compensation, the key thing in the first instance is to be clear on what you want to achieve with whatever plan or plans you may introduce. Once you achieve clarity on those objectives, you then look at the various available approaches and go with what best meets your needs.
Among the types of grants that have emerged as popular choices in recent times are restricted stock units (RSUs) and performance stock units (PSUs). Both share similarities, while also differing in some key respects. If you plan to introduce or expand equity compensation in your business and want to look beyond stock options, then you may well find yourself considering RSUs and PSUs.
Here, we will look at RSUs vs PSUs, detail the key information relating to both, highlight the similarities and differences between the two, and ask what individual businesses will consider when deciding which is likely to be a better fit for them.
RSUs – key features
An RSU is best thought of as a promise made by an employer to an employee that they will receive shares at some point in the future – the vesting date – as long as certain conditions are met, usually relating to that employee remaining with the company for a minimum period of time and/or achieving specified performance goals. It is also common for a liquidation condition to be attached, meaning that stock can only vest after an IPO or in the event of the business being formally taken over by another company.
So, the first important point to note is that no company stock is issued at the time of an RSU grant. Instead, the company pledges that stock will be awarded at some point in the future, as long as the conditions set down on day one – the vesting conditions – are met by the recipient.
The vesting process can be either “graded” or “cliff”, with the former meaning that stock vests in chunks over time, while with the latter, all stock vests at the same moment, upon completion of all elements of whatever set of conditions were attached.
So, if the RSUs of a given employee are linked to a time condition, e.g., remaining with the company for four years, the terms of the agreement might see 25% of the grant vest over each of those four years. This would be an example of “graded” vesting.
However, if there is a liquidation condition, then no matter what other time and performance-related conditions may have been satisfied, most likely 100% of stock will be withheld until that event – whether an IPO or takeover – occurs. This is “cliff” vesting – all at once.
While at first glance, RSUs linked to a liquidation event might seem unattractive to an employee, there are upsides, particularly from the taxation perspective.
No tax falls due when the RSUs are initially granted, but recipients become liable for ordinary income tax based on the FMV at the point that the stock vests. Depending upon the terms of the agreement, this may or may not prove problematic for recipients. For example, it is not unusual for companies to withhold a portion of the shares to cover relevant taxes for individuals.
A key point here relates to whether a company is public or private. When RSUs in a public company vest, it is relatively straightforward for individuals to sell on the open market whatever number of shares are required to meet tax obligations. However, it can be more complicated for employees of private companies. Even if those companies are moving towards an IPO or expect to be bought over in the future, that will be of little practical benefit to individuals who, upon the vesting of their RSUs, may find themselves with a substantial tax bill, but no obvious way to sell shares to fund the payment.
In those circumstances, a specific condition linking vesting to an IPO or takeover removes the danger that recipients may have to dip into their own resources to pay an income tax bill linked with the RSUs becoming actual shares. More specifically, in recognition of the lock-up period typically associated with IPOs, this kind of condition usually states that RSUs will vest six months after going public.
When recipients then look to sell their shares, they will be liable for capital gains tax on the difference between the FMV of the shares when they vested and when they are sold, assuming that value has increased. So, if the FMV was $15 at vesting, and $25 at the time they are sold, the capital gains liability will be assessed on $10 per share. When recipients sell within one year of vesting, they pay short-term capital gains tax, but if they sell after that they will be liable for long-term capital gains tax, with the latter scenario usually leading to a lower bill.
It is also possible to defer tax liability at the point of vesting by moving the RSUs into the company’s nonqualified deferred compensation (NQDC) plan. This creates an opportunity for the value of the award to continue to grow for another period of time without a tax bill falling due.
- Relatively speaking, RSUs are a quite straightforward form of equity compensation. The vesting schedule will be clear, and it is easy for recipients to calculate the value of their award.
- Recipients are receiving free shares, i.e., no purchase required.
- Because recipients don’t pay for the shares, they will always retain some value, even if the FMV declines between grant and vesting. For example, if an individual is granted 3,000 RSUs when the FMV is $20, but by the time the shares vest that valuation has fallen to $15, they will still be up on the deal. The starting point is zero shares and zero outlay, so even with the share price decline they go from holding shares worth $0 to shares worth $45,000 before tax (3,000 x $15).
- These awards encourage employees to remain with the company into the mid-term, as most individuals will not want to leave while still holding RSUs, thus forfeiting whatever portion has yet to vest.
- From the admin perspective, there is less time and effort involved in tracing and recording RSUs versus actual stock. Remember, an RSU is basically a promise to RSUs are cost-efficient. You are offering compensation without incurring any cost upfront.
- If working for a private company, the tax situation at vesting can prove complicated, as outlined above.
- If an employee leaves before all RSUs have vested, they will usually forfeit whatever percentage remains.
- Depending upon the FMV at vesting, the value of the stock may not prove to be as great as originally anticipated.
- RSUs are priced when the stock vests, not when the initial grant is made, so employers don’t know what their ultimate value will be at the outset.
- Beyond that uncertainty, if stock value does not increase noticeably over time or even declines, employees may become more disappointed than motivated.
PSUs – key features
PSUs or performance shares are awarded to employees based on how a company performs over time, with the number of shares awarded usually linked to how well the business fares on key metrics over a given period; typically, three years. So, the more overall performance exceeds expectations set down at the outset, the more shares will be distributed to plan participants.
Among the metrics most commonly used by companies to measure performance in this context are relative total shareholder return, return on capital, and earnings per share. A typical PSU plan might include some or all of these or even more measurement criteria. If the goals set down at the outset are achieved during the performance period, then the PSUs vest and plan participants receive the equivalent number of shares as was specified in the initial agreement. If performance far exceeds what was envisaged as the minimum target, there will be a provision to award participants with a greater number of shares than if the company had merely matched that minimum expectation.
In this sense, the awards can be graded. It is not merely a matter of achieving minimum performance targets and receiving an agreed number of shares. Seeing the company achieve that minimum standard by the end of the performance period will trigger the vesting of assigned PSUs, but there may be a range of different vesting points relative to overall performance on the measured metrics.
All relevant clauses and scenarios will be set out in the plan agreement, including details on the target metrics and their measurement, the performance period, the vesting date, the minimum performance achievement required to trigger vesting, the range of vesting possibilities relative to measured performance, and assuming multiple metrics, the relative weighting for each, if applicable.
Also, under some agreements, the measurement will not merely apply to internal company metrics, but also to how competitor companies fared during the same performance period. So, if the company fares better or worse than the competition during that period of time, there will be implications for vesting.
The logic here is to continue incentivizing employees to give of their best efforts, above and beyond the point where an initial vesting target may be met. When the PSU agreement includes a provision for different vesting points, it offers the opportunity to participating employees to fare even better in terms of final shares allocation.
In instances where performance targets have not been met during the performance period, the relevant PSUs do not vest and are instead cancelled.
Part of the rationale behind the focus on company performance – as opposed to time-related conditions, as typically seen with RSUs – is that investors, shareholders, and regulators alike approve of this emphasis, as it sends a signal that the company is actively committed to aligning pay, performance, and long-term shareholder value.
Similarly, the logic internally is that setting up an incentive plan in this way will incentivize managers and executives to focus first and foremost on business activities that will impact positively on shareholder value.
The taxing of PSUs is similar to that of RSUs, in that there is no liability around the initial award, income tax falls due when the shares vest and are delivered to individuals, and capital gains tax will apply in the event that the eventual sale price exceeds the FMV of the shares at the time of vesting. It is also possible to defer the initial moment of tax becoming due by placing PSUs into the company’s NQDC plan.
Because of the similarities between RSUs and PSUs, most of the advantages and disadvantages outlined above for RSUs also apply here. However, in addition to those points, the following also merit mention in the context of PSUs.
- Performance shares can help individuals to build personal wealth when the company performs well.
- PSUs can act as an effective means of motivating and rewarding employees.
- This form of equity incentive can help to align the interests of individual employee with those of the company.
- Depending upon the circumstances, performance shares can prove quite costly for the company.
- Another potential downside is that the prospect of rewards in the short-term may encourage individual employees to engage in risky behavior that may not be in the best interests of the business.
RSUs vs PSUs – the differences
The key difference between RSUs and PSUs relates to what triggers the vesting of stock. Whereas with RSUs, time will sometimes be the only condition linked to vesting, PSUs eschew this link, as well as individual performance markers, and instead focus exclusively on the performance of the company as a whole, as measured by specific business-related metrics.
Also, with RSUs, the agreement between employer and employee will be for a set number of shares to be handed over once the pre-defined goal has been achieved, i.e., if the terms of the deal are linked to an employee remaining with the company for at least the next three years, once that period of time elapses – if the deal provides for cliff vesting – the agreed number of shares will be handed over all at once.
Whereas, with PSUs, as outlined above, it tends not be as straightforward. Because PSUs are linked to overall company performance, it is not unusual for the eventual share awards to be linked to precisely how well the company fares on the metrics being measured. So, meeting a basic or stated minimum goal will lead to a certain number of shares vesting, but the final shares award will be linked to the extent to which the business exceeds those minimum performance targets; in other words, a sliding scale. So, the better the company performs relative to expectations specified in the plan agreement, the more shares will be handed over to those participating in the plan.
Is one better than the other?
When you pose the question in absolute terms, then there is no clear answer. Better to think of it in these terms – Which one is the best fit for your business and what you want to accomplish with your employee equity compensation strategy?
As made clear above, PSUs and RSUs are similar in many respects. The most obvious difference relates to what triggers the vesting of shares. For our purposes here, if we think of it in terms of RSUs being linked to time and PSUs to company performance, then the difference between the two is made clear.
Against that backdrop, if your top priority is retention of staff, then you might lean more towards RSUs, with the need for individuals to remain with the company included as perhaps the only condition linked to the eventual vesting of shares.
PSUs, meanwhile, will always be linked to overall company performance, so they may represent the best approach when a company is first and foremost concerned with looking to motivate key employees and encourage behavior in the workplace consistent with the long-term success of the company.
Of course, you could just as easily say that all companies will want to encourage staff retention and have those employees engaged in their work and committed to the long-term success of the business, so these are not mutually exclusive objectives.
Again, which form the equity compensation best suits the needs of a company at a given time will depend upon the circumstances of that individual business.