Things you should know about RSUs for Pre-IPO Companies

Restricted stock units (RSUs) are a form of equity compensation which is granted to employees in more established companies such as late-stage startups and pre-IPO (Initial Public Offering) companies. RSUs represent a promise to issue company stock to an employee at a future date, subject to certain conditions. One particular challenge that Pre-IPO companies.

What is RSU?

Restricted stock units (RSUs) are a form of non-cash employee compensation offered by an employer without employees having to purchase them. The award of an RSU is the full value of the company stock instead of the appreciated portion like that offered by stock options.

They are called ‘restricted’ because employees often don’t earn the right to their RSUs immediately, but rather when a defined period has passed. This process is called vesting and it is a waiting period before all the conditions, e.g. time-based and/or milestone-based requirements, have been satisfied to allow the employee to earn the company stock.

6 things to know about RSUs in a pre-IPO company

RSUs in private and pre-IPO companies differ from those offered by public companies in a number of ways, such as stock liquidity and taxation. When RSUs in a private companies vest, the holder will owe taxes but may not be able to sell the stocks to cover their tax bills due to its illiquidity, i.e. stocks in private companies are not traded on public markets. This scenario differs from that in public companies, where shares are typically more liquid to be traded anytime.

1) RSU vesting – Double trigger vesting in a pre-IPO company
In a public company, RSUs are typically subject only to time-based vesting, meaning employees need to stay with the company for a certain period of time before they can own their RSUs.

In pre-IPO companies RSUs typically include a double-trigger vesting provision in the plan. This means two vesting conditions, e.g. both a time-based requirement and an event, usually an IPO, have to be satisfied. With this mechanism, the first condition alone doesn’t trigger vesting. The employee only owes taxes when both events occur. By that time, they’ll likely be able to sell their RSUs to cover the tax bill and resolves the problem of having to pay taxes out of their own pocket upfront.

You should always ensure to explain clearly the general taxability of your employees’ vested RSUs at the IPO so that they can plan ahead for this event.

2) Tax implications – Income tax at vesting and CGT at sale
Through clear communication and education you can help your employees to understand their potential tax liability which can help them with effective financial management and avoid unexpected financial burdens.

i. RSU Vesting:
At vesting, income tax on the full FMV (Fair Market Value)_of the stock, subtracting the RSU cost basis is taxable. If there’s no purchase required, the cost basis of the RSU is zero. At this stage, employers will typically withhold 22% for federal income taxes. Be mindful that some high earners don’t get fully covered – see the next section for more details. After reducing the number of stocks to cover their tax bill, the remaining stocks will be deposited into the participant’s account.

ii. Selling RSUs:
If selling after a year of vesting, the additional gains will be considered long-term capital gains. The tax rates are typically lower than ordinary income tax rates.

If selling the vested RSUs immediately, before they increase or decrease in value, capital gains tax (CGT) can be avoided.
 
3) Tax withholding
Once the second trigger occurs all of your employees’ vested stocks will be subject to taxation at the same time. If they have accumulated a lot of stocks this could move them to a higher tax bracket and result in an increase in their tax payments correspondingly.

It means the employee would owe taxes in addition to the 22% of federal withholding tax rate.
For example, if your employee had $12,500 in RSUs become taxable at vesting [250 shares x $50 FMV at vesting], the total withholding tax amount would be $2,750 [$12,500 x 22%]. If their tax bracket was 35%, then they would be under-withheld.

To avoid any surprise tax bills you should endeavor to communicate this with employees so they can prepare for the event.

4) Impact of IPO – Watch out for the lock-up period
You may assume your employee’s RSUs have finally vested and they can sell their stocks to pay their taxes at the IPO date.

However, most companies will have a lock-up period, usually 90-180 days following IPO. This means stockholders won’t be able to sell their stocks until the lock-up period ends. The purpose of the lock-up period is to help maintain stability in the stock price, retain employees and prevent a flood of shares from hitting the market, as this could potentially lead to a rapid decline in the stock’s value. An important note to taxpayers is that lock-up periods don’t mean the tax event will get delayed.

Many companies will withhold 22% of their employees’ RSU income, as discussed above, to cover the federal tax rate, while some companies may set the second trigger to be the date when the lock-up period ends.
 
5) Employment termination – Treatment for vested and unvested RSUs
Job termination almost always stops vesting and it’s important that you and your employees are aware of how vested shares and unvested stocks are treated in this scenario.

Vested RSUs: They will stay with your employees.
Unvested RSUs: Employees who leave your company with unvested RSUs will lose the right to receive those company stocks. These will be returned to the company.

The only exception occurs in certain situations when vesting may be allowed to continue or may even be accelerated, e.g., death, disability, or retirement, and these should be set out in conditions of your plan at outset.

6) Employee communication
Given the complexities surrounding RSUs in a pre-IPO company, it’s essential to help employees understand their RSUs so they can truly appreciate their potential long-term value and their benefits as an integral part of their overall compensation package.

That’s why employee communications comes into play. So, what should be included in the employee communications plan?

1. Overview of RSUs, e.g. definition, how it works, and benefits
2. How might they benefit your employees? e.g. financial well-being, no upfront purchase needed, etc
3. Tax implications
4. Key dates for employees to be aware of, e.g. plan invitation date, closing date for applications, vesting and settlement date, etc.
5. How to join? e.g. via an employee portal or third party provider such as Workplace Solutions
6. How they can ask a question about their plan
7. FAQs, e.g. if what happens to my RSUs if I quit, tax implications in different scenarios, etc.

It’s important to consider your audience when developing an effective communications plan. Think about the tone and language used, communication channels for delivering your message and the schedule for your communications in the lead up to the launch of and then onwards throughout the lifecycle of the plan.

Want to find out more?

At J.P. Morgan Workplace Solutions, whether you’re a private, pre-IPO or public company, we can help you implement and administer your RSU plan as well as providing employee communications support so that you can focus on your core business.

Powered by our technology and a team of equity professionals, we can help support your teams and help your employees to take full advantage of restricted stock units.

Request a free demo to find out more about our equity management software and services.