Equity Compensation Options: How RS and RSUs Differ from Stock Options

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

When a company preparing for an IPO offers equity compensation to directors or key employees, the appropriate arrangement depends on when shares are delivered and the recipient's cash burden. Alongside stock options, restricted stock (RS) and restricted stock units (RSUs) are potential choices. These arrangements differ in when recipients become shareholders, the corporate approvals required, and the timing of taxation and liquidity. Before choosing a scheme by its name, the company needs to decide who should hold shares and at what stage.

Three basic forms of equity compensation

Arrangements that deliver the value of a company's shares as compensation fall broadly into three forms: stock options, RS and RSUs.

Stock options grant a right to acquire shares at a predetermined exercise price. The recipient becomes a shareholder only when that right is exercised. RS, by contrast, delivers the shares at the outset, subject to contractual transfer restrictions and forfeiture provisions, such as acquisition by the company without consideration when the recipient leaves office. An RSU initially grants a promise to deliver shares once a service period or performance target has been satisfied. The actual shares are delivered after the conditions are met.

All three link compensation to future corporate value, but they differ fundamentally in what recipients receive and when they become shareholders. Stock options provide an acquisition right, RS provides the shares themselves, and RSUs provide a promise of future shares. This distinction directly affects tax treatment, Companies Act procedures and administration.

Vesting structures for RS and RSUs

Both RS and RSUs may have service or performance conditions, but the shares reach recipients at different times. The legal substance of an RSU depends on its contractual terms. This article addresses arrangements that deliver shares after the conditions have been satisfied.

RS recipients become shareholders when the shares are delivered. For ordinary shares, voting and dividend rights normally remain in place despite contractual transfer restrictions. The actual rights also depend on matters such as the class of shares and the relevant record date. At the same time, the agreement restricts sales to third parties for a specified period and provides for the company to acquire the shares without consideration if an event such as early departure occurs. If the arrangement instead provides for a paid repurchase, the procedures and financial restrictions on acquiring treasury shares also require separate review.

RSUs do not deliver shares at grant. Recipients obtain a future entitlement to receive shares if the conditions are satisfied; they do not become shareholders at that point. Shares are issued or delivered only after the specified service period or performance criteria have been satisfied, a process known as vesting.

For recipients, RS creates shareholder status at the outset, but they may have to surrender shares already acquired if conditions are not met. RSUs confer no shareholder rights before delivery, and the promised entitlement is designed to lapse if the conditions fail. For the company, RS involves a share issuance or disposal of treasury shares at the initial delivery. An RSU postpones the share-delivery procedures, but it does not necessarily permit postponement of approvals required when the compensation award is decided.

Four points of comparison with stock options

Four practical differences matter when comparing stock options with RS and RSUs.

The first is payment of an exercise price. Under ordinary stock options requiring a cash contribution, recipients pay the exercise price when exercising their rights. That payment is required even for tax-qualified options. RS and RSUs involve no exercise of share options, and some arrangements allow recipients to acquire shares without using their own cash. However, a structure requiring no contribution under the Companies Act must be distinguished from one in which a monetary compensation claim granted by the company is contributed in kind.

The second is compensation value when the share price falls. If the share price is below the exercise price, exercising an option at that time produces no gain. However, the possibility of a future price increase means the option's economic value does not necessarily fall immediately to zero. RS and RSUs are linked to the entire value of the shares, so value may remain even after a price decline. The risks of the shares losing their value, forfeiture or lapse nevertheless remain.

The third is the timing and calculation of dilution. Where new shares are issued, the number of issued shares increases on exercise for stock options, on initial share delivery for RS, and on subsequent share delivery for RSUs. Whether RSU delivery precedes option exercise depends on each arrangement's terms. Delivery of treasury shares does not itself increase the number of issued shares, but it affects matters such as voting percentages. Capital planning should separately show calculations based on current shares and calculations that include shares scheduled for future delivery.

The fourth is the sense of directly owning shares. An option holder has a right that can be exercised in the future. RS delivers the shares at the outset, which can help recipients feel personally involved as shareholders. I consider that sense of ownership another reason to choose the arrangement when seeking to encourage directors to take the effects on share prices and dividends into account in their decisions.

Differences between listed and unlisted companies

A listed company satisfying Article 202-2 of the Companies Act, discussed below, can deliver shares as directors' compensation without requiring a cash payment or other contribution. The special rule has conditions, including conditions concerning eligible recipients. Procedures differ depending on whether the recipient is a director or employee and which corporate body decides compensation.

At an unlisted startup, however, RS and RSUs are not as straightforward to use as stock options. Three main obstacles explain this.

The first is share valuation. Because RS delivers the shares at grant, an appropriate valuation must be established at that time. Listed companies have an objective reference in the market trading price, while unlisted companies face the work and cost of valuation for each grant.

The second is a mismatch between taxation and liquidity. RS delivers shares first, but the timing of taxation depends on whether they qualify as specified restricted shares or equivalent shares for tax purposes. For RSUs too, the name alone does not establish the tax timing: the vesting and delivery conditions must be examined. Before introduction, the company needs to consult a tax advisor about its own deductibility and withholding obligations as well.

The third is the limited ability to turn shares into cash. Unlisted shares cannot be freely sold on a market in the same way as listed shares. With an option, a recipient can avoid the funding burden by choosing not to exercise. An RS recipient, however, may continue holding shares subject to transfer restrictions with no buyer available. This lack of liquidity can be a material burden for officers and employees before an IPO.

Companies Act procedures and tax review

When RS or RSUs form part of officers' compensation, the company must address compensation regulation as well as Companies Act procedures for issuing shares for subscription.

Article 361(1)(iii) of the Companies Act (Japanese) requires decisions on the maximum number of shares and other matters prescribed by Ministry of Justice Order when shares for subscription are delivered as directors' compensation. If the articles of incorporation do not specify these matters, a shareholders' meeting must resolve them. In contrast, a structure involving an in-kind contribution of a monetary compensation claim requires review of the applicable matters under, among other provisions, items (i) or (ii) and (v) of that paragraph. The names RS and RSU alone do not justify treating every award as an item (iii) resolution. Separate provisions govern decisions by the compensation committee in a company with a nominating committee, etc.

Article 202-2 provides a special rule for a company issuing listed shares when it issues shares or disposes of treasury shares in accordance with the terms established under Article 361(1)(iii). It removes the need to specify the payment amount and payment date or period, instead requiring a statement that no cash payment or other property contribution is needed and specifying the allotment date. It does not eliminate all other subscription terms, such as the number of shares, or all necessary approvals. Paragraph (3) provides substitutions for directors and executive officers of a company with a nominating committee, etc.

An unlisted company, or an award to employees outside the special rule, needs a structure following the ordinary procedures for shares for subscription. An in-kind contribution of a monetary compensation claim requires review of the property contributed, its value and whether an inspector's investigation is required. Many unlisted companies are non-public companies under the Companies Act, but "unlisted" and "non-public company" have different meanings. Identify the body responsible for approval by checking the transfer restrictions in the articles of incorporation and the company's governance structure.

For tax purposes, the National Tax Agency's Income Tax Basic Circular 23-35 Common-5-3 (Japanese) generally treats income from specified restricted shares or equivalent shares as arising when the transfer restrictions are lifted. It also addresses certain cases involving death and states that shares which the company acquires without consideration are not taxed. It is therefore inappropriate to describe RS uniformly as taxable on delivery. Check the specific contractual terms against the relevant requirements, income classification and valuation rules.

Choosing and designing an arrangement

Compare the recipient's cash burden at three separate stages: grant, exercise or share delivery, and taxation. Tax-qualified stock options defer taxation at exercise when the conditions are satisfied; they do not remove the requirement to pay the exercise price. For RS and RSUs too, a structure requiring no cash contribution differs from one that also avoids a need to fund tax before a sale.

When choosing an arrangement, set out the timing of shareholder status, recipients' positions, service and performance conditions, and the treatment of early departures in a term sheet. Then decide whether to issue new shares or dispose of treasury shares and assign responsibility for the necessary approvals and tax review. At an unlisted company, recipients need an explanation before grant of the valuation method and cost, when shares may become saleable, and the burden if tax arises before a sale.

Equity compensation design combines capital planning, corporate law and tax decisions. We discuss the role of options in Stock Options as Capital Policy and specific issues in Advanced Issues in Tax-Qualified Stock Options. When introducing RS or RSUs, have the attorney and tax advisor review the same term sheet so that corporate approvals and tax assumptions align.