Facebook's pre-IPO regulatory filings (click here) with the Securities and Exchange Commission (SEC) highlight a common issue with equity compensation programs -- the tax bill can be very large and trigger a burdensome withholding obligation. Facebook reports that its employees and contractors hold about 378.5 million restricted stock units (RSUs). Each RSU represents a right to receive one share of Facebook stock when the RSU vests. The RSUs will vest approximately six months after the IPO. Facebook is estimating a median IPO price of $36 per share. If that valuation holds up, the RSU holders will vest in equity compensation worth approximately $13.6 billion. Assuming a combined state and federal tax rate of 40%, that will produce a tax bill of about $5.5 billion.
A big tax bill can be a nice problem to have; however, employers are required to withhold taxes with respect to equity compensation as it vests, and the IRS wants to be paid in cash, not shares. So where does the money come from? In Facebook's case, it looks like they are planning to use a good chunk of the money they will receive from selling shares to the public in the IPO for business purposes; however, Facebook will likely hold back a percentage of the shares each employee would receive upon vesting of the RSUs and then use some of the cash from the IPO to make the required tax payments. This is sometimes referred to as "netting down" the shares the employees receive. It is convenient for employees, but requires the employer to have enough cash to make the tax deposit.
There are two other common ways to handle tax withholding in situations like this. The taxes can be withheld out of the employees' other cash compensation (e.g., bonuses and salaries). But those amounts are often not enough to cover the taxes, and the employees still need to be able to buy food and pay their mortgages. The alternative is to have the employees pay the employer an amount equal to the required tax withholding. This is usually accomplished by having the employees sell enough shares to cover the required tax withholding.
The Facebook numbers are eye-popping and reflect a scale that is relatively unique. Even if your equity compensation program isn't on the scale of Facebook's, some advance planning is necessary to ensure there are no surprises when the taxes come due on your equity compensation program.