Restricted Stock Units: The New Currency of the Valley

Sara Craven
The Valley has experienced a dramatic shift over the years from using the competitive value proposition of stock options to attract and retain top talent, to offering restricted stock units as an attractive enticement. This trend started to develop as the incentive models of stock options showed diminishing effectiveness; employees began to realize that a start-up company would have to go public and rise significantly in value for an option strategy to pay in spades. In reality, companies can stay private for a very long time and market volatility can make the difference between hitting the lottery and using your company option agreement as scratch paper. In extreme market volatility, options - at least temporarily - can be worthless if the company's stock price falls below the exercise price of the options.
 
According to research conducted by Radford, a leading global provider of compensation intelligence and consulting services to the technology and life sciences sectors, data show the clearest move to Restricted Stock Units (“RSU’s”) occurred during the 2008/2009 recession. The stock market downturn during this period essentially wiped out any in-the-money value in option grants for employees. Prior to that, the stock market downturn of 2000–2002 revealed another weak point of options. As a result, over the last 15 years restricted stock units have become the answer to valued incentive plans with some industries in the Valley gaining more traction than others.
 
A very specific Valley event also helped push the change. In 2007, Facebook realized that its number of stock option holders would soon eclipse the 500-shareholder limit imposed by the SEC. The same issue forced Google to go public in 2004. Restricted stock units don’t count against the shareholder limit. And so the restricted stock unit revolution was born.  
Start-up companies often use the restricted stock method because unlike outright compensation, it does not involve the need for immediate access to cash; in effect, RSUs represent fully valued compensation upon vesting. That being said, they are more often found at later stage companies. RSUs are a potentially ideal solution for a company that needs to provide an equity incentive in an environment where the current company valuation is robust but not likely to be monetized through an Initial Public Offering (“IPO”) or acquisition for several years. As a result, they are very common among later stage companies that close venture financing rounds at valuations north of $1 billion (examples include Palantir, Uber, Snapchat, Dropbox, and Pinterest). For these companies, stock options would be worthless to employees until the company had actually attained and exceeded its newly inflated strike price.
 
A grant of restricted stock units is always worth something, unless the stock price falls to zero. It also makes the employees’ pay dependent on the performance of the company’s stock, giving them extra incentive to improve the company’s performance. This, in turn, has the added benefit of aligning company employees and officers with their shareholders. 
 
For employees and officers with restricted stock units who have never played in this sandbox before, there are some very important wealth and tax considerations at stake. If the restricted stock units make up a disproportionate percentage of your wealth, you’ll want to explore diversification strategies. We understand that you most likely love the company and every way they are changing the world, but markets rule and once vested, an accumulation of restricted stock units with frequent vesting have the potential to change your wealth trajectory. Developing a strategy around diversifying this significant nugget of wealth may be pertinent to your family’s long term financial success. 
 
The tax consequences of equity-based employee compensation are not always straightforward and are sometimes poorly understood. With the increase in personal tax rates over the past two years - especially for California residents - and with wide use of stock options and RSUs, it’s more important than ever to understand the tax impact of these plans. 
Employees of pre-IPO companies may face a very real problem of coming up with the resources to pay the required tax withholding that is due immediately upon RSU vesting. Because there’s no public market for the shares, private company employees can’t sell shares to raise cash to pay withheld taxes.  At this point, it would be appropriate to engage a secondary market liquidity provider.
 
Another critical component of tax strategy is the identification of the date the holding period begins for long term versus short term capital gains treatment.  As of this writing, the date of vesting is when the holding period begins for gain treatment. However, companies may impose lengthier vesting periods such as in the case where the vesting occurs at either 1) the date determined in the stock agreement or 2) six months after an IPO, whichever is later. The holding period clock starts ticking in this case at the later date. This distinction is critical. If you sell the stock before one year and a day after the determined vesting date, you are subjecting yourself to significantly higher taxes. Both state and federal short term capital gains are taxed as ordinary income. The federal tax can be as high as 39.6% (2015) compared to long term capital gains rates of 20% (www.marketwatch.com). 
  
It can be well worth your time to explore how to apply tax strategies to your own situation, and you should seek the help of your tax accountant and wealth advisor to help guide you in executing them properly. Don’t leave money on the table, or worse yet, paid out in taxes that proper strategy could otherwise potentially minimize.

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