Restricted Stock Unit - RSU

In the beginning, there was a salary. And on the second day, compensation grew more complex. So to the salary was added “The Bonus.” Then, on the third day, The Almighty Compensation Committee added stock options to salary and bonus.

The goal? To better align the actions of senior management with the equity shareholder-owners of the company.

But then along came all kinds of crazy restrictions and risk issues and taxes...with simply the handing out of stock options to senior management. One big problem? Their strike price was usually determined by whatever price the company’s stock was trading at when they were handed out. So if the overall stock market went from trading at 24 times earnings to 15 times earnings, the company's stock options could end up being massively underwater, i.e. if they carry a strike price of, say, $100 a share...they need to be above that 100 dollar number to be worth anything. So when the stock tanks to only 70 bucks, through no fault of the company’s management, they have a long way to go before the options are even worth anything.

The idea was that stock options were too volatile, and didn’t really account for situations like the above...and the reverse, where the management is “overpaid” for simply being at the company during a time when the overall stock market multiple went from a low-ish multiple to a high-ish one. Again, through no genius acts of their own. Just luck and timing.

So instead of paying in stock options, on the Fourth Day, along came RSUs…or Restricted Stock Units. Management was paid in actual shares of stock, not just options on them. And in smaller numbers. That is, with a grant of, say, 100,000 stock options given at the $100 a share strike price where the stock was trading now...that grant might have a calculated value based on the volatility of the company of say $4 million as they were vested into over 4 years, or a million a year based on the Black Scholes theorem, which is the default calculate of option value…at least in America these days.

So instead of that grant, an equivalent RSU grant might be 40,000 RSUs with the same vesting privilege, but with very different payment and dilution dynamics. And tax consequences to the grantee as well.

So one big change with an RSU grant instead of a stock option grant is the volatility of pay. That is, if the stock in that time period of 4 years went to $250 a share, the option grantee would be $150 in the money for 100,000 shares, and would be 15 million dollars to the good. Or in-the-money on their options. And if the stock was flat at $100, the grantee would have gotten nothing, at least nothing from the options. Highly volatile situation. Bad for morale as well, as employees then stress over short-ish term stock price fluctuations rather than just running the business. But with stock options, there are no taxes to the grantee until she exercises them. At that point, the options (if sold as a same day sale) get ordinary income tax treatment, i.e. high taxes.

For RSUs, the dynamics are different. Taxes are usually owed when those RSUs are granted. And then vested into as if they are compensation. That is, on the first year anniversary of a 4-year vest of a $400,000 RSU grant, the employee would owe long-term gain tax on the $100,000 of that RSU.

The other big difference is dilution to shareholders. In the case of the options grant, the number of shares outstanding is increased in this reasonably realistic example by 100,000. When those shares are sold, the shares exist forever as part of the shares outstanding; they don't just go away after the end of the year, as would be the case in a cash bonus.

In the case of RSUs there is still dilution, but it’s at half the rate of the options. And other risk-reward dynamics come into play as well; if the stock goes to $250, then instead of the 15 million bucks made by the option holder, the RSU grantee gets 40,000 times $250, or $10 million. Less dilution…more safety to the owner of those RSUs, i.e. the employee.

But in another case, where the stock is flat at 100...or even drops to 80... he RSU holder still gets…something. Like...in the worst-case scenario here of 80 bucks a share times 40,000 shares, the RSU holder still gets 3.2 million bucks' worth of equity for her pleasure in running the company. She’s not so far out-of-the-money that she gives up on the notion of there ever being real value to stock options had she gotten those instead of RSUs, and just quit to go to another company or competitor.

The structure of an RSU then is simply more directly reflective in making management act or behave more like owners than lottery ticket winners, in the form of stock options. They then have less incentive to swing for the fences with wild risks, and potentially risk company bankruptcy. And then (hopefully) simply manage the company, as if they owned the whole thing themselves.

So, uh...where were we? Oh, right…the Almighty Compensation Committee saw everything that they had done, and...they saw that it was good.