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Long-term Incentive Compensation Considerations

As companies are struggling with attracting, retaining, and motivating employees and balancing pay for performance and retention, two of the more prominent tools that are often considered are Restricted Stock Units (RSUs) and Performance Stock Units (PSUs). The purpose of this article is to provide information relating to both, including the key differences and consideration for deciding which could be a better fit.

Overview of RSUs

  • Definition – Employer promise to employees that they will receive shares in the future, provided certain conditions are met. Typically, this requires a certain length of employment and/or achieving specified performance goals. These conditions may include a liquidity event, so that the RSU only vests upon a sale or a public offering. No stock is provided at the RSU grant, but a promise is made that the stock will be awarded at some event in the future (vesting date).

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.

  • Employee Tax Treatment – No tax falls due when the RSUs are initially granted, but recipients must pay ordinary income tax based on the fair market value (FMV) at the point that the stock vests. When an employee wants 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, if value has increased. 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.
RSU Advantages
  • For Employees:
    • RSUs are a quite straightforward form of equity compensation, with a clear vesting schedule and it is easy to calculate the value of their award.
    • Recipients are not required to pay anything up front to receive their shares. As such, they will always retain some value, even if the FMV declines between grant and vesting.
  • For Employers:
    • These awards encourage employees to remain with the company, for at least part of the vesting cycle, as most individuals will not want to leave while still holding unvested RSUs. These plans are straight-forward from an administrative standpoint and very cost effective.
RSU Disadvantages
  • For Employees:
    • For private companies, valuation issues arise at vesting that may complicate tax situation.
    • If an employee leaves before all RSUs have vested, they will forfeit remaining award.
    • The value of the stock may not prove to be as great as originally anticipated.
  • For Employers:
    • RSUs are priced when the stock vests, not when the initial grant is made, resulting that employers will not know that value at the date of the award.
    • If the stock value does not appreciate significantly, or even declines, employees will not value the award causing negative impacts.

Overview of PSUs:

  • Definition – Awarded to employees based on company performance over a set period, with the number of shares awarded tied to key metrics over a given period – usually three years. The better the performance the greater the number of shares awarded. 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.
  • Typical Performance Metrics – Often include:
    • Relative total shareholder return
    • Return on capital
    • Earnings per share

The other variations often extend to beyond internal company metrics, but also to how competitor companies performed during the same period.

In instances where performance targets have not been met during the performance period, the relevant PSUs do not vest and are instead cancelled. Accordingly, unlike time related conditions that are part of RSUs, investors, shareholders, and regulators alike approve of this emphasis, and creates alignment with pay, performance, and long-term shareholder value.

The taxing of PSUs is like that of RSUs, in that there is no liability around the initial award: income taxes are triggered when the shares vest and capital gains tax will apply if the eventual sale price exceeds the FMV of the shares at the time of vesting.

Because of the similarities between RSUs and PSUs, the advantages and disadvantages outlined above for RSUs also apply here. There are a few other issues that also apply to PSUs.

PSU Advantages
  • For Employees:
    • Performance shares can help individuals to build personal wealth when the company performs well.
  • For Employers:
    • PSUs can act as an effective means of motivating and rewarding employees and helps align the interests of an individual employee with those of the company.
PSU Disadvantages
  • For Employees:
    • PSUs may encourage employees to engage in risky behavior that are not in line with company objectives.
  • For Employers:
    • Performance shares can prove quite costly for the company.

RSUs vs. PSUs – What are the key factors that employers should consider in decide the optimal vehicle?

  • Vesting motivation – Typical RSUs are time based only, where PSUs only use of time to measure company performance.
  • Fixed vs. variable awards – RSUs are for a fixed number of shares to be awarded when time conditions are met. As PSUs are linked to overall company performance, final shares awarded will be linked to the extent to which the business exceeds minimum performance targets; the better the company performs relative to performance metrics, the more shares awarded. Is one better than the other?
  • Retention is primary objective – RSUs may be more appropriate as the sole condition for vesting.
  • Encourage behavior to align with company success – PSUs are always to overall company performance, and therefore should encourage consistent behavior aimed at achieving the long-term success of the company.

If these goals are in fact overlapping, then it may be prudent to issue a combination of RSUs and PSUs, with the weighting tied to overall objectives and other total compensation strategies.