United States: Restricted Stock: The Solution for Underwater Options?

Microsoft’s recent announcement that it would begin to issue restricted stock to employees, instead of stock options, has provoked discussion as to whether more venture-backed technology-based companies should adopt the same approach. Over the last couple of years, stock options have not provided a significant incentive for employees of many of these companies, and accounting and regulatory issues, including issues associated with repricing options, have raised questions about the viability of a strictly options-based equity compensation strategy. Nevertheless, stock compensation continues to play a critical role in attracting talented employees to developing companies.

Historically, start-up companies have sold so-called founders’ stock to some original key employees at a time when the stock presumably has a very low per-share value. In many cases, the founders’ stock is subject to forfeiture restrictions, either from the outset or later when outside investors come into the picture. Following the initial start-up period, however, after the company’s stock has appreciated in value, developing companies have typically granted their employees stock options, and not restricted stock. This article will compare the advantages and disadvantages of restricted stock and stock options, including the tax treatment of each form of compensation, with a view to determining whether restricted stock is becoming a practical alternative to stock options for periods after the founders’ stock is issued.

Restricted Stock and Stock Options — the Similarities. Fundamentally, restricted stock and compensatory stock options have several things in common: (1) both are used to create employee incentives to maintain a long-term relationship with his or her employer and/or achieve certain performance goals; (2) both typically are subject to some form of vesting requirements (in the case of restricted stock, forfeiture or redemption at cost upon the termination of employment or failure to meet a financial target, whereas stock options typically are not exercisable until after a period of service by the employee or the achievement of a financial target); and (3) both derive their value from the value of the underlying stock.

Restricted Stock and Stock Options — the Differences. Although restricted stock and stock options have the similarities noted above, their value to employees can be quite different. Since companies granting restricted stock do not typically require employees to pay a significant purchase price for the stock, an employee who is granted restricted stock receives compensation that is essentially equal to the value of the stock. In contrast, a stock option requires the employee to pay an exercise price, which usually is equal to the value of the underlying stock at the time the option is granted, and the employee benefits only if there is future appreciation in the value of the underlying stock. (The difference in economic benefits between a stock option and restricted stock can be reduced to some degree by granting an "in-the-money" option, although a stock option that is significantly in the money at the time of grant could be subject to the same tax rules as a restricted stock grant.)

The employee’s exposure to risk is different as well. Because an individual can realize value from restricted stock regardless of whether the value of the underlying stock increases, and because the company will not receive any (or a significant) payment for the stock, the company will usually issue fewer shares pursuant to restricted stock grants than it would be willing to issue pursuant to stock options, if options were used. As a result, in comparison to a typical stock option, restricted stock reduces the downside risk to the employee, but it also reduces the upside potential because fewer shares are involved.

From the perspective of the company and its shareholders who are not receiving restricted stock, the picture is somewhat different. Because restricted stock rewards employees even if the stock does not appreciate, employees may not be motivated to increase their efforts after receiving the stock. Indeed, a major criticism of restricted stock grants is that they constitute pay for continued employment regardless of the company’s success.

Tax Treatment of Stock Options. A compensatory stock option generally does not result in any tax liability when the option is granted or when it vests. Instead, when the option is exercised, the spread between the fair market value of the stock at that time and the option exercise price generally will be taxed as ordinary income (although special rules apply for "incentive stock options"). Any future appreciation or depreciation will be treated as capital gain or loss when the shares are sold, and that gain or loss will be long-term capital gain or loss if the shares have been held for more than one year after the option was exercised. Thus, an option provides considerable flexibility to the employee to control the timing of the taxable events (exercise and sale of stock).

Tax Treatment of Restricted Stock. The timing of taxation for restricted stock grants is more rigid. Under the default rule, the grant of restricted stock is not a taxable event. When the stock vests, the individual must include — as ordinary income — the spread between the value of the stock at that time and the amount paid (if any). Any future appreciation or depreciation generally will be taxed as capital gain or loss when the stock is sold, and that capital gain or loss will be long-term capital gain or loss if the stock is held for more than one year after the vesting date.

The individual can elect out of the default rule applicable to restricted stock by filing a "Section 83(b) election" within 30 days after the grant date of the restricted stock. By making the election, the individual agrees to include — as ordinary income — the spread between the fair market value of the restricted stock when issued and any amount paid for the stock. If the election is made, the vesting of the stock will not be a taxable event, and any post-grant appreciation or deprecation in the value of the stock generally will be taxed as capital gain or loss when the stock is sold. A Section 83(b) election therefore protects against a tax liability when the stock vests and starts the employee’s long-term capital gain holding period.

If an employee purchases restricted stock of a privately-held business at a time when the value is relatively low, it is standard practice for the employee to file a Section 83(b) election. If no election is filed, the employee will potentially have a tax liability later when the shares vest based on what may be a much higher stock value at that time. However, in a private company the employee will have no assurance of liquidity to fund that tax liability. In contrast, a Section 83(b) election is almost never filed by an employee making a bargain purchase of restricted stock in a publicly-held company. The election would cause the individual to pay tax currently on the bargain element even though there is no assurance that the shares will actually vest. In addition, if the individual makes the Section 83(b) election and the stock is later forfeited, the individual will not be entitled to recover any of the tax paid as a result of the election.

When to Use Restricted Stock. When does restricted stock make sense? For a public company or a larger private company that does not anticipate dramatic appreciation in the value of its stock, a stock option with a strike price equal to fair market value at the time of grant may be perceived as providing little economic upside to the recipient. In these situations, grants of restricted stock may be an attractive way to motivate employees. Not surprisingly, one of the various interpretations of Microsoft’s announcement is that the software giant has recognized that it is no longer a fast-growth company with a stock price likely to increase substantially over the near term.

For privately-held developing companies that expect significant appreciation in the value of their stock (i.e., typical venture-backed, emerging growth companies), restricted stock programs are still unlikely to be attractive beyond the founders’ stock stage. The employees of private companies generally cannot sell stock (or otherwise come up with funds) to pay the significant tax liability that results from the restricted stock grants. Also, for a private company, using restricted stock can significantly increase the number of current shareholders which, in addition to the regulatory issues discussed below, can result in higher costs and some administrative inconvenience. On the other hand, limited grants of restricted stock to a very few key executives may be useful in some situations (e.g., when a company is trying to attract a key executive), as part of a larger package of equity incentives.

Implementing a Restricted Stock Program. If a company is considering implementing a program for grants of restricted stock, it should take into account a number of considerations. First, if the company is private, the company should ensure that employees are able to pay taxes on the compensation income attributable to the stock grants, either through cash bonuses or through company buybacks of some of the shares granted. Second, the company should review the accounting treatment of restricted stock. The company should also consider issues that may arise under securities laws, including the effect of the increase in the number of shareholders if a private sale of shares to an acquirer is contemplated.

Conclusion. Even in light of Microsoft’s recent announcement, the general approach to equity compensation by privately-held developing companies (i.e., heavy reliance on employee stock options) is unlikely to change. In the right situation, however, including the very early start-up phase, restricted stock can be a valuable part of a company’s compensation package, provided that the company can address the tax and regulatory issues discussed in this article.