Written by: Joseph W. Bartlett, Co-Chair of VC Experts
Although the subject of discussion in this article is not new, nonetheless my experience is that a significant percentage of the parties involved in the capital markets … particularly the private capital markets where emerging growth companies are organized to travel the Conveyor Belt,  from the embryo to the IPO … are unfamiliar with restricted stock units (“RSUs”).
The grant of a restricted stock unit (“RSU”) by a corporation to an employee gives the employee the right to receive a share of the corporation‘s stock, or if the RSU agreement so provides, its cash value equivalent, upon satisfaction of one or more specified vesting conditions.
The vesting conditions may be either time-based (completion of a specified period of employment following the date of grant) or performance based (achievement of performance goals over a specified measurement period), or both.
To the extent the RSUs granted to the employee become vested, the employee will receive either the number of shares that have vested, or if the RSU agreement so provides, a cash amount equal to the shares’ fair market value.
In the usual case, the RSU’s are “settled” by the delivery of the shares or payment of the cash amount at the time the RSUs vest. However, an RSU agreement can, and often does, provide for the payment or delivery of shares to be deferred until the occurrence of some later specified date or event; but if payment is to be delayed beyond March 15 of the year following vesting, then the payment-triggering event must be one permitted under Section 409A of the Internal Revenue Code.
Under Section 409A rules, the payment event could be termination of employment, or it could be the occurrence of a change in control , as defined for Section 409A purposes , which would be a typical private company exit event when cash can be realized to enable the employee to sell enough shares to pay the tax … and keep the rest. An IPO, another typical exit event, would not be a 409A-permissible payment event for an already vested RSU. But an RSU agreement could provide for the RSUs to both become vested and payable upon the first to occur of an IPO, a change in control (including one not meeting the Section 409A definition), termination of employment, or at some specified date corresponding to the investors’ expected exit and realization date, e.g., the 7th anniversary of the date of grant.
For federal income tax purposes, an employee is not taxed with respect to a grant of RSUs either at the time of grant or at the time of vesting. He is subject to tax only upon his receipt of the shares or their cash equivalent at the time the RSUs are settled. At that time, he is taxed, at ordinary income rates, on the then fair market value of the shares he receives, or the amount of the cash he receives.
In a number of respects, RSUs compare favorably with other forms of equity grants, as a medium for delivering incentive compensation to a private company’s employees.
- A grant of RSUs delivers full share value to the employee. It provides him not only with upside potential but also downside protection. He can realize value from the grant even if the date of grant value of the RSUs should later decline. In contrast, with an option grant the employee will realize value only if and to the extent that the shares covered by the option increase in value after the grant date.
- A grant of restricted shares also delivers full share value to the employee, and in addition, provides the employee with an opportunity for capital gains treatment on eventual sale of the shares. In contrast, when RSUs are settled, the then value of the shares is subject to tax at ordinary income rates. But as indicated above, RSUs are not taxed at the time of grant, nor at the time of vesting if settlement of the RSUs does not occur until a later date. As a result, it should be possible in most cases to structure an RSU grant so as to delay settlement, and thus, taxation, until a realization event occurs. This may not be the case with a restricted stock grant. The employee would have to pay tax, at ordinary income rates, on the value of his restricted shares either at the time of grant if he makes a Code section 83(b) election, or at the time the shares vest if he doesn’t make the election. He may therefore be subject to tax, at ordinary income rates, with respect to a substantial portion of the ultimate value of his restricted shares well before an exit event occurs permitting a sale of the shares.
- Like an RSU grant, an employee is not taxed with respect to a stock option at the time of grant or at the time of vesting. He is subject to tax at the time he exercises the option, if it is a nonqualified stock option (“NQSO”), or if it is an incentive stock option (“ISO”), at the time he sells the shares acquired on exercise of the option.  In either case, the grant of a stock option, whether an NQSO or an ISO, would permit tax to be delayed until the occurrence of a realization event, since a stock option grant can permit the option to be exercised at any time during its term after it becomes vested. Although in the case of an NQSO, tax would be at ordinary income rates, as is so with an RSU, in the case of an ISO, the increase in value of the shares from date of grant to date of sale could qualify for tax at capital gains rates, subject to certain limits and conditions. However, there are several negatives to be considered in connection with a stock option grant.
(i) Valuation Issues. Tax law requirements  mandate that the exercise price of a stock option not be less than the fair market value of the underlying shares at date of grant. Failure to comply with this requirement could result in significant adverse tax consequences for the employee under Section 409A. Share valuations for a private company are an inherently uncertain matter. To minimize the exposure to adverse treatment under Section 409A, the exercise price for the option usually would be established based on an independent third party valuation.
(ii) Dilution. Because an option delivers value to the employee only to the extent that the fair market value of the shares at the time of exercise exceeds the option exercise price, it would be necessary for an option grant to cover a greater number of shares than a grant of RSUs or restricted stock, in order to deliver an equivalent economic value to the employee. As a result, an option grant would mean more dilution for the investors as compared with an economically equivalent grant of RSUs or restricted stock.
(iii) Limits on Capital Gain treatment for ISOs. Capital gain treatment for an ISO is available only if the shares acquired on exercise are held for at least 1 year following the date of exercise of the option, and 2 years following the date of grant of the option. In the usual case, an employee holding an option on shares of a private company would not want to exercise his option until there is an IPO or other realization event, and will want to sell the shares he acquires on exercise of the option as soon as practicable after that event occurs, in order to (a) fund his payment of the exercise price for the shares, and (b) avoid loss of value in the shares in a highly volatile market that could bring a significant drop in share price prior to the end of the ISO-required holding periods. If the employee does sell the shares before the end of the ISO required holding periods, the increase in value of the shares since date of grant will be taxed at ordinary income rates, instead of capital gain rates. 
All things considered, for many private companies the grant of RSUs may be the best vehicle for delivering incentive compensation to the company’s executives, despite the fact that the values so delivered will be subject to tax at ordinary income rates.
After all, the objective is to give an incentive to the executives which pays them for navigating the company’s trip from “the embryo to the IPO” or to a trade sale. And, if the tax is at ordinary income rates the answer is ‘so what?’… as long as the executives receive and are able to sell enough shares to make a big difference in the executive’s life.
 Bartlett, “From the Embryo to the IPO, Courtesy of the Conveyor Belt (Plus a Tax-Efficient Alternative to the Carried Interest), ” The Journal of Private Equity Winter 2011, Copyright (c) 2011, Institutional Investor, Inc.
 The definition would include the acquisition by a third party of more than 50% of the total fair market value or voting power of the company’s shares, or more than 40% of the total gross fair market value of the company’s assets.
 However, the “spread” at the time of exercise of an ISO might be subject to the alternative minimum tax (“AMT”) in the year of exercise.
 Other limits on capital gains treatment for ISOs: (i) ISO treatment is available only for shares with a total grant date value of up to $100,000, in respect of all of the employee’s ISOs that first become exercisable in any calendar year; and (ii) ISO treatment is available for an option only if exercised by the employee during employment or by the end of the 3rd month following termination of employment. If an exit event has not occurred before the end of the 3 month post-termination exercise period and the employee wants to wait until an exit event does occur to exercise his option, doing so will result in loss of ISO status for his option and taxation at ordinary income rates, instead of capital gain rates, for the “spread” when he does exercise the option.