Valuing Restricted Stock Units
Valuing Restricted Stock Units
This blog provides a general understanding of how Restricted Stock Units work, their history, and the factors to consider when assessing their value.
(Originally Posted November 10, 2020)
Executive compensation continues to reach new expectations thanks, in part, to savvy benefits and stock enticements aimed at not only attracting talent but keeping them from leaving. However, finding the right balance between fair compensation and incentives for both sides is easier said than done.
Consider, if you will, that in the past, executive compensation was primarily comprised of a mix of salary, benefits and bonuses, most notably: Stock options. Those stock options gained notoriety back in the 1990s dotcom ride when, seemingly overnight, tech company employees with stock options were suddenly millionaires. The same couldn’t be said years later when the bubble burst leaving, most famously, Enron employees with stock that was worthless.
Since then, employers have slowly moved away from offering stock options that in addition to carrying risk, suffer from complicated taxation and a difficult cash out processes. Instead, more companies have turned to Restricted Stock Units (“RSUs”) as a compensation incentive. Between 2003 and 2005, the median number of stock options granted by Fortune 1000 companies declined by 40%, while the median number of RSUs increased by nearly 41% during the same period ¹.
Restricted Stock Units – What’s in it for me?
RSUs are a method of compensation issued to an employee in the form of company shares or a cash equivalent. RSUs are issued through a vesting plan and are distributed after completing a specified number of years of service. Once vested, the employee receives shares from the company or the cash equivalent which they can either continue to hold or sell at their discretion.
RSU Sample Scenario
Kevin is a manager for a publicly traded oil and gas company. As part of his annual compensation agreement, Kevin receives 500 RSUs from his employer that are tied to a two-year vesting period. After two years or when Keven reaches the vesting period maturity date, he will receive one common share for each RSU. At the time of issuance, the stock price is trading at $20 per share, meaning the intrinsic value of the RSUs he received is $10,000 (500 RSUs x $20). However, this does not necessarily mean Kevin is entitled to this money. For instance, if Kevin decides to leave his employer before the RSUs are vested, he may receive nothing. Similarly, if the stock price fluctuates between now and when the RSUs vest, Kevin may receive proceeds worth more or less than the $10,000 should he decide to cash out once vested.
Valuing an RSU? Here are a few considerations:
Broadly speaking, the value of an RSU is a product of the following inputs:
- The stock price at the Valuation Date;
- The expected volatility of the stock price through the vesting period;
- The taxes payable upon vesting;
- The likelihood of the RSUs vesting; and
- The time value of money.
Upon vesting, the RSU holder receives shares in the company (or cash equivalents), which can be sold at their discretion. Therefore, the stock price at the Valuation Date may serve as a baseline value for the RSU. Of course, there are other factors that may materially increase or decrease this baseline value.
Expected Volatility of the Stock Price through the Vesting Period
Most stock prices are not stable – their price may increase or decrease between the valuation date and the vesting date. Fortunately, CBV’s are able to calculate the impact of notional hedging strategies that notionally eliminate the price risk between the valuation date and the vesting date. The volatility of the stock (i.e., the measure of the variation of stock prices over time) is an important input when determining the cost or benefit of implementing these hedging strategies.
Taxes Payable upon Vesting
The employee receiving an RSU (i.e., the holder) does not incur any taxes when the RSU is initially granted. Instead, RSUs are considered income upon vesting and a portion of the shares (or cash equivalents) may be withheld to pay income taxes. The employee’s income tax rate, therefore, may be an important input when assessing the RSU’s value.
Likelihood of Vesting
RSUs are issued through a vesting plan and are distributed after completing a specified number of years of service. Therefore, the likelihood of the employee reaching the specified number of years for the RSUs to vest must be considered when assigning value to an employee’s RSUs.
Time Value of Money
The time value of money is the concept that money in the future is worth less than the same amount of money in the present. Since RSUs vest in the future, any future proceeds need to be discounted to account for the time value of money.
At Davis Martindale, we have experience valuing all types of compensation arrangements. If you need an expert to value your RSUs, we would love to work with you.
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