Facebook (FB) employees holding 225 million shares of restricted stock will be $5.2 billion richer in a few days. On October 29, these people will be able to freely sell shares as their lock-up period expires. The event is bittersweet, as FB stock went public at $32 per share and the stock closed at $22.56 on Thursday. The amount being paid is about 30% less now.
The redemption of shares represents a huge moment as all the effort and time expended by FB employees will be monetized. Some populists say these people do not deserve to become millionaires. This perspective is unfair as many employees took a huge risk working for FB in the early years when success was not assured by any means. The FB episode is a perfect example of how entrepreneurship sometimes pays off handsomely in this country, a rags to riches story, if you will.
Deferred compensation results in great wealth in only a rare number of situations. For start-up businesses, if they survive, the payoff can be huge. But, the survival rate of these new companies is low. Only in a few, and well publicized, instances do the employees of de novo businesses ever make a killing. But, deferred compensation in the form of stock options and restricted stock (RSUs) can serve many purposes for start-ups and seasoned companies.
In the case of FB, deferred compensation consists of RSUs. An alternative could have been stock options. The primary difference between the two forms of compensation is that RSUs have real value when issued; stock is awarded to employees at a price per share based upon the current valuation of the company. Stock options represent a right to buy shares at a set price (the strike price) for a certain number of years, but are worth zero intriniscally at the time of issuance (strike prices are always set above current market value).
Depending upon the future expectations of the stock, one form of compensation is more lucrative than the other. The numbers of shares that are valued at say $100,000 are different with RSUs versus stock options. Because the RSUs have intrinsic value immediately, an employee will receive less of these units than they would if they received stock options, which have no value unless the stock price increases above the strike price. For this reason, for stock that has a very high appreciation rate, stock options would provide a better yield. If the stock grows slower, the same would be true for RSUs.
In any case, when RSUs are sold, they are taxed at 45% of the current value of the stock (for millionaires); many of the FB employees will become millionaires. For stock options, the amount above the strike price is taxed at the same rate when the options are exercised. In the FB situation, the company will withhold 45% of the shares and deliver 55% of the shares to the employees, which they may sell or retain. So, if all the shares are sold, employees would receive $3.9 billion in cash, and $2.3 billion of stock would be retired by FB, which would then pay the latter amount in cash to the IRS. Note: this method of redeeming the RSUs will decrease the number of FB shares outstanding, an event that will favorably impact earning per share.
Even before an actual redemption event, the stock of companies with large amounts of outstanding RSUs depresses the current value of stock. In banking vernacular, it is referred to as overhang. When the stock actually hits the market, it can have a significant impact on the current price of the shares. In August, some FB insiders were able to sell shares and the stock fell by 6% on the first day.
IPO shares are almost always subject to lock-up periods. A typical IPO lock-up is anywhere from 90 to 180 days after the offering date. This is done to try to keep order in the trading of the shares, especially in the early days after the IPO.
For new companies like FB, restricted shares and options are used in lieu of current cash compensation, when the liquidity of the company may be limited. Additionally, it is a way to compensate early investors and employees for the risk associated with working for a fledgling company that has a high risk of failure. The shares are issued at extremely low valuations at the time of issuance. In successful situations, the price of stock could be $1.00 or less, as compared to $10, $20 or $30 offering prices. The arithmetic is simple; many people stand to make huge profits if things go favorably.
In established companies, RSUs and options have multiple purposes. For one, the employees who receive them have the same long-term interest in the success of the company as public shareholders; if the stock increases in value because the company is profitable and well managed, everyone benefits (the opposite is also true). RSUs and stock options are saleable only after a vesting period, which could be as long as seven years. And, there could be corporate performance requirements that will impact the delivery of the stock. The time standard makes it more difficult for key employees to leave the company and work for competitors.
Deferred compensation has been a cornerstone tactic for critics of Wall Street compensation. Not only do these people want bankers to receive compensation over an extended period of time, they want the deferred compensation to be at risk during the vesting period. In other words, it can be “clawed back” or decreased if the employee does not act properly (as defined) or loses money for the company.
Deferred compensation in the form of RSUs and stock options are an excellent way to pay employees and align their interests with public stockholders. From an earnings perspective, all forms of compensation including RSUs and stock options are an expense that flows through a company’s income statement.