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Understanding RSUs and PSUs: A Guide for Investors

For investors analyzing public companies, it's important to understand different forms of employee compensation, including equity-based incentives like Restricted Stock Units (RSUs) and Performance Stock Units (PSUs). These instruments are widely used, especially in the tech sector, to attract, retain, and motivate talented employees.

Restricted Stock Units (RSUs)

RSUs represent shares of company stock that are granted to an employee, but with a vesting schedule attached. The shares are not issued initially, but are instead credited to the employee's account over the vesting period, which typically ranges from 3-5 years. For example, a company may grant an employee 1,000 RSUs annually over 4 years, with a 1-year cliff and then quarterly vesting after that. This means the employee wouldn't receive any actual shares for the first year. Then after year 1, 25% (250 shares) would vest. Over the remaining 3 years, the other 75% (750 shares) would vest in 12 equal quarterly increments of 62-63 shares. The employee cannot sell the vested shares until they actually take possession, which may be deferred until employment termination or a fixed date. Taxes are paid on the market value of the shares at vesting. RSUs align employee and shareholder interests by tying compensation to stock performance and employment longevity. For the company, RSUs enable share-based pay while managing share dilution over time. For investors, RSUs are an expense that reduces net income, though there is no cash outlay. The shares are included in the diluted outstanding share count used for EPS calculation once vested.

Performance Stock Units (PSUs)

PSUs are an even more direct link between pay and performance. They are similar to RSUs but with an additional performance criteria attached, which is typically based on achieving specific operational metrics or stock price milestones. For instance, an employee may be granted 5,000 PSUs that can become 0-10,000 shares based on the company's 3-year total shareholder return relative to its peer group. If the company maxes the performance criteria, the full 10,000 shares would vest. If it misses targets, a reduced amount or potentially zero shares would vest. PSUs have vesting schedules like RSUs, but the number of shares ultimately awarded is variable based on whether the performance goals are achieved. Like RSUs, taxes are paid upon vesting on the market value of the earned shares. For companies, PSUs help drive key strategic, financial, and stock price performance. They are particularly common for executive compensation to create intense incentives aligned with company objectives. Investors should scrutinize the details of PSU plans, performance metrics used, degree of difficulty in achieving targets, share amounts at stake, etc. Estimating future share dilution is trickier with PSUs since the number of shares earned can fluctuate.

Accounting and Valuation Impact

From an accounting standpoint, companies must recognize the fair value of RSUs and PSUs as compensation expense over the respective vesting periods. This reduces net income, but is a non-cash expense. The valuation of these instruments uses complex models like Black-Scholes to estimate fair value at grant date. For RSUs, this is relatively straightforward since the number of shares is fixed. For PSUs, the uncertainty around the performance criteria complicates the calculations. Companies make assumptions about expected volatility, risk-free rates, dividend yields, and most critically for PSUs - the probability of achieving the performance goals. Higher probabilities translate to higher fair values and expenses. The net impact is that expenses are "smoothed" over multi-year vesting, rather than hitting all at once. But over time, the full fair value expense does get realized. For investors, these non-cash expenses reduce profitability metrics like EPS, P/E ratios, and free cash flow. While not impacting cash flows currently, they do represent future potential dilution and cash outflows when shares vest and are exercised down the road.

Analysis Considerations

When analyzing RSU and PSU compensation plans, investors should look at the total number of shares authorized, shares outstanding, run rate of grants, and remaining share pool available. Companies will periodically need investor approval to increase the share reserve to enable future grants. Evaluating potential future dilution is key, especially for high-growth companies using equity incentives aggressively. The degree to which performance criteria for PSUs are realistically achievable is also worth scrutinizing. Very tough goals reduce the valuation impact but may de-motivate employees. Easy goals create a windfall without driving true performance. Governance aspects like vesting requirements, share holding policies, clawback provisions, and responsible use of equity pay should also be considered. For mature companies, investors may prefer more cash-based compensation versus heavy equity incentives. But for emerging companies, equity pay aligns interests, conserves cash, and can be a competitive recruiting advantage.

Tax Implications

There are also tax implications for companies and employees related to RSUs and PSUs that investors should understand. For employees, RSU and PSU vestings create taxable compensation at ordinary income rates based on the market value at vest date. This creates a potential cash flow need to pay those taxes. Companies get a tax deduction equal to that same amount, helping offset some of the expense impact. However, the deduction may be delayed if employees hold shares longer before selling them. There can also be differences between the book expense calculated for accounting purposes and the actual tax deduction based on the market value at vest date creating further book/tax timing differences. Overall, RSUs and PSUs remain widely used forms of employee incentive compensation that create complex financial reporting, corporate governance, and valuation considerations that investors must analyze carefully across industries.

RSUs and PSUs allow companies to attract talent and motivate employees with ownership, while investors need to analyze their financial implications around expenses, dilution, and alignment of interests. Looking closely at a company's RSU and PSU practices can provide helpful insights into its compensation philosophy and culture.

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