Over the last several years, companies have adopted ever more sophisticated equity compensation plans. Brought on in part by accounting rule changes that make the issuance of any kind of stock-based compensation an expense when they are granted, many companies have lightened up on stock options and turned to various forms of stock grants that must vest before the shares can be issued. For employees who felt they had figured out their stock options, these grants have added a new layer of complexity. This article presents six questions I get all the time from clients who have received restricted stock, restricted stock units (RSUs), or performance shares.
“I received restricted stock units (RSUs) as part of my long-term incentive compensation plan. Some of the long-term employees talk about when they used to receive stock options but the company doesn’t issue those any more. Are RSUs a good deal?"
For several reasons, starting back in 2005 most companies began to reduce the number of options issued and, in some cases, had replaced them entirely with grants of restricted stock or restricted stock units (RSUs). In fact, according to their 2018 Trends And Developments In Executive Compensation, Meridian Compensation Partners survey of 127 public companies’ current practices in equity grants for executives, restricted and performance shares have continued to accelerate in popularity over other equity compensation alternatives, so it shouldn't surprise employees that their company is now granting them in place of stock options.
Most of the time, the stock is granted with a vesting schedule attached. This means that the stock won't actually be paid to you until some future date. This also means that the future value of the stock is unknown, as with stock options. But unlike options, which can go underwater, a grant of restricted stock will almost always have some value. While stock options have more potential upside, some employees like the fact that their equity compensation won't completely evaporate, and companies prefer the somewhat simpler accounting.
Why do you get fewer restricted shares than stock options?
Each restricted stock/RSU grant has full value based on the stock price, while the value of stock options is technically only a right to buy stock at your fixed exercise price. The true value of options depends on the stock's appreciation above the exercise price at some future point. In a grant of restricted shares/units, however, the value of each share is readily ascertainable and is much higher than the value of a mere option. As stock options are more difficult to value and must now be expensed by your company when they are granted, companies have often cut back on them. Restricted stock also poses less risk to the employee since, most of the time, stock doesn't go to zero. As many of you may know, stock options are quite capable of expiring out of the money instead of increasing in value.
I used to get restricted stock, but now I get restricted stock units. What's the difference? Why the change?
Restricted stock units (RSUs) are similar, but there are a few important distinctions between the two grant types. With restricted stock, you can elect to pay taxes at the time of grant with a Section 83(b) election,a tax treatment choice that will allow you to treat the eventual capital appreciation in your grant as a capital gain. We help employees decide if this election is right for them and in some limited situations, if you understand the risks, it can make sense to start the capital gains holding period early when the stock price is depressed. With RSUs, you cannot elect to pay taxes early. However, some plans do allow a little tax planning by permitting the deferral of share delivery. For various administrative reasons, companies find RSUs easier to use, and this may be why RSUs have become more popular than restricted stock for broad-based grants.
"My restricted stock vested this year. The company has issued my shares, but there aren't as many in my account as there were in the grant. Where are my other shares?"
The vesting of your shares is a taxable event. The company is required to withhold income and payroll taxes from the gross amount of shares you receive. Think of it as a paycheck in stock. The value of the award will show up on your W-2 at the end of the year as compensation. Some companies give you the choice to pay the taxes with a check, to sell just enough shares for taxes, or to have shares automatically held back (i.e. share surrender) to cover the taxes.
Example: You are granted 10,000 RSUs. At share delivery, the company holds back 2,500 shares. Therefore, only 7,500 shares will appear in your account. If shares are withheld (the most common method), the number of shares you receive will be less than the gross amount of the award. The value of the shares used for taxes will show up on your W-2 at the end of the year in the boxes for taxes withheld. Because you have paid the taxes on these shares, they will have a tax basis equal to the value the company used to determine the compensation value of your award. Often, this value is the closing price of the stock on the date of the award or on the day before.
"Last year, my restricted stock vested. I received some shares in my brokerage account. What happens if I sell those shares? Should I sell them or hold them?"
The answer is, "It depends on when you sell them and at what price." Remember, you paid tax on the receipt of these shares last year. If you hold these net shares for more than a year and sell them for a price higher than the price on the day you received them, the appreciation will be taxed at long-term capital gains rates.
When an equity plan participant asks for advice about what to do with restricted shares that are about to vest, or how to plan for them as part of a broader financial strategy, I usually suggest planning to sell them as soon as they vest, depending on how much of the questioner’s net worth is already concentrated in company stock. I say, "Ask yourself, knowing everything you do about the company you work for and how much of the stock you already own, would you buy your company stock with a cash bonus of similar value? If not, you probably don't really want to hold these company shares either."
Here is the financial-planning rationale for this advice:
This stock was given to you as part of your compensation. It was granted some time ago and vests in pieces over time. Since the market will continue to affect the remainder of the unvested portion of your grant, why take market risk with the shares you have just received? Unless you have ownership guidelines as part of your employment agreement, there is no reason to let a disproportionally large piece of your net worth be concentrated in your company stock. Most employees who receive stock grants have other equity compensation that is far from expiration or will vest in the future. They also may have company stock in their 401(k) and may even have money accumulating to buy shares in an employee stock purchase plan. I often suggest that more than 25% of your equity holdings in company stock is too much.
Some advisors suggest that there should be a different threshold for company stock when the company pays a high dividend. High dividends are indeed an attractive attribute to have in one's equity holdings, but your company isn't the only good company with a strong dividend. Diversification has shown, over and over again, to be a defense against the risk that is unique to each company. For every example of a company with a long, seemingly dependable history of rising earnings, dividends, and stock prices, I can show you an example of an iconic brand-name company that has temporarily stumbled. You don't want that to be your company, in which you have a big portion (50%, 75%, 90%?) of your net worth, during the month before you retire. Ask the folks at Lehman Brothers, a company that traced its roots to 1850 and was once the fourth-largest investment bank in the US, how smart it turned out to be to have their life savings tied up in their (beloved) company stock.
"Last year, my company granted me some performance shares. They vest according to a company profit formula over three years. This year, the company reached its target for the first third, but I didn't get a third of the shares. Why?"
The one thing that makes all performance share plans look similar is that they have some sort of metric or goal that must be achieved in order for the shares to be paid out. According to the Equilar 2017 Equity Compensation Study, relative Total Shareholder Return (rTSR) has become the preferred measure used in long-term incentive plans among S&P 500 companies. The report shows that the use of rTSR increased from 41.6% in 2011 to 57.4% in 2015. Metrics such as return on capital (30.6% of the surveyed companies) and earnings per share (29.2%) are other widely used measures. A 2017 survey of the S&P 250 by Frederic W. Cook & Co. found that 83% of the companies surveyed use a three-year performance period. So your company is going along with the crowd if these metrics are part of your performance share award formula.
"So why didn't I get a third of my award in the first vesting?"
There are several possible reasons, as these plans take many forms and vary more than traditional stock options or restricted stock. Perhaps the plan requires continued employment for three years or uses a cumulative three-year goal. It may be that shares are vested and issued on a "percent of goal" basis for the three-year period. For instance, your plan may award shares at 100% if the goal of a 20% increase in earnings per share is reached by the three-year mark, but something less if the results are a 10% or 15% increase. Companies can also fine-tune metrics to different business units, departments, or even individual employees' performances.
Many companies are enamored of performance shares. However, it is quickly becoming evident that with these grants, unlike other types of equity compensation, there may not yet be any best practices that all companies adopt. By their nature, these plans are all a little bit different than one another, making them sometimes confusing.
"I'm so confused. Why does my company have so many different stock plans?"
Companies now take a more portfolio-based approach to their equity grants than they used to. Each stock plan serves a different purpose and carries a different combination of upside potential and downside risk, like a typical investment portfolio. Stock options and restricted stock are important for corporate recruitment, retention, and motivation, largely because other companies have similar compensation plans.
I call this the “Lake Wobegon Effect”. Humorist Garrison Keillor tells us that in the fictional town of Lake Wobegon, all the men are handsome, all the women are beautiful, and all the children are above average. Compensation consultants make their living by helping companies figure out what it takes to attract the best talent, keeping these key employees focused on their goals, and retaining them when other companies discover what a good job they are doing. These consultants have pushed their clients to adopt ever more customized stock compensation plans. Performance plans can theoretically be designed to zero in on the complex set of issues that face a department, team, or even an individual to provide a unique set of incentives funded with the company's stock. Comparative metrics are used to ensure that executives and talented people get paid enough (but not too much) in the right combination of current cash compensation, stock, and deferred compensation to prompt "optimum" business outcomes. Voilà! Everyone is targeted to be above average.
Performance shares make both investors and regulators happy by creating a much stronger and more transparent link between pay and performance. The conscientious member of a public company's compensation committee believes performance shares can send a signal to shareholders that the company is trying to further align pay, performance, and long-term shareholder value—in other words, that the company is trying harder to become a better corporate citizen. Among researchers, the conclusions are mixed about whether this is having the intended effect. In 2010, the consulting firm Pay Governance, which reviews SEC proxy filings, observed that executive payouts under both annual and long-term incentive plans were closely linked to actual company performance as reflected in total shareholder return and in growth of earnings per share. But in 2015, Cooley PubCo concluded that "there was not any conclusive evidence that the positive relationship was there."
For all the added complexity, you'd think companies would devote significant resources to communicating the terms of their equity compensation to their employees. However, a 2014 survey by Ernst & Young revealed that while 80% of companies provide informational materials to their employees when they receive a grant, only 31% continue to do so regularly after the time of grant. Nearly half of the companies do not notify grant recipients of upcoming vesting dates. A 2017 study by E*Trade revealed that 69% of stock plan participants “…weren’t sure how to maximize the benefit of (the) plan”. These plans also cost public companies hundreds of millions of dollars each year to implement, and manage but, an ongoing UBS study most recently updated in 2016, found that 45% of plan participants perceive little or no value in their equity awards. Without robust, company-sponsored efforts toward employee financial literacy, it may be a while before the full potential of complex performance-based equity compensation is realized. This makes it important to ask questions, both at your company and with qualified stock plan financial planners and advisors.