Five Things Employers Should Like About Restricted Stock

Employers large and small often ask us how they can reward key employees for their contributions to the success of the company and provide a meaningful inducement for them remain with the company. These companies often have annual incentive plans, but they typically are looking for a longer term incentive that might encourage the key employees to think more like, well, owners. Of course, any one (or a combination) of the basic panoply of equity-based compensation arrangements – stock bonuses, stock options, restricted stock, stock appreciation rights and phantom stock – might be appropriate for a business, depending on its circumstances and goals, and what’s right for one employer may not be right for another. But there are at least five reasons why a program of restricted stock grants remains appealing for a variety of companies, large, medium and small: (1) it involves real stock; (2) it creates a meaningful element of employee retention; (3) the income tax consequences are straightforward; (4) the grantees really do have skin in the game; and (5) an employer can add features that help preserve the control of the current owner(s).

Real Stock

Unlike phantom stock or stock appreciation rights, restricted stock is real stock. Once issued, the holder of restricted stock enjoys most of the rights enjoyed by any shareholder. Specifically, the holder of restricted stock is generally entitled to vote (if the stock issued to him or her is voting stock), is entitled to receive dividends (if any are declared on that class of stock) and would be allowed to participate in a stock split or similar capital structure transaction. The only important right that the holder of restricted stock does not enjoy is the right to sell or otherwise transfer the shares. (More on that in a moment.)

One caveat: some corporate lawyers don’t love restricted stock precisely because it is real stock and the holders of real stock have rights under state law (such as the right to receive notice of shareholder meetings, the right to review corporate books and records, etc.) Of course, that’s the result under a stock option plan as well, after the options are exercised.

Retention

As noted, the key “restriction” that comes with restricted stock is that the holder does not have the right to sell or otherwise transfer the stock until his full ownership rights become vested. Vesting can be structured in a wide variety of ways. A restricted stock grant may vest all at once on a given date or upon the occurrence of a given event, or it might vest gradually over a period of years. For example, a company might award 100 shares of restricted stock to an employee and the award might vest over five years in increments of 20 shares; or the company may award 100 shares that all vest on the third anniversary of the grant date; or the company may award 100 shares that vest upon the attainment of a specified performance goal. The key is this: the employee must remain in the employ of the company on the vesting date in order gain full ownership of the shares.

Take an employee who receives the grant of 100 shares on January 1, 2011 and who terminates employment in June 2013 (two and half years after the grant date). Under the first vesting approach, that employee would have vested in 40 shares. Under the second approach, the employee wouldn’t have vested in any shares (because he was not employed on the third anniversary of the grant). Vesting schedules can be as long or short as the company sees fit, but the vesting schedule must be set at the time of the grant. (Vesting is often accelerated in the event of death or disability, and sometimes in the event of a sale of the company, so long as the employee is still employed at the time.)

Straightforward Tax Consequences

The income tax consequences of restricted stock are well established for both the employee and the employer. The employee is taxed on the fair market value of the vested shares in the year(s) in which they vest. That income is considered ordinary income (in the nature of compensation) and the employer is entitled to a compensation deduction for the same year(s). Taking our first example, the employee would be taxed on the fair market value of 20 shares of company stock in 2012 (when the first portion of the grant vests) and then on the fair market value of another 20 shares in 2013 (when the second portion vests). Importantly, it’s the fair market value in the year of vesting (not the year of the grant) that is used to determine the tax liability. So if the company continues to perform well, and the value of the stock appreciates over time, the tax liability will increase as well. That is, unless the employee makes a special one time election to pay taxes on the aggregate fair market value of the whole block of restricted stock in the year of the grant. That election is available under Section 83(b) of the Internal Revenue Code and is beyond the scope of this modest post. (Suffice it to say that an employee who receives a grant of restricted stock from a start up company with a current fair market of zero and loads of potential for speedy growth should consider making the Section 83(b) election.) Finally, when the employee goes to sell the stock in the future, the gain on the sale will be capital gain just like it would be for any sale of stock.

Recipient Will Have Skin in the Game

Many business owners don’t like the idea of just “giving” stock to their employees, which is one reason why outright stock grants are rarely seen. But the recipients of restricted stock earn the shares as part of their compensation package by working through the vesting period AND (as noted) they do have to pay income taxes on the value of the shares when they vest. It is certainly a great deal for the grantee – I know I would rather pay the taxes on $5,000 worth of stock than pay the full $5,000 to get the stock – but the out of pocket tax payment still represents a meaningful outlay that certainly will feel like an investment to most employees. Nevertheless, some employers view the obligation to go out-of-pocket to pay taxes as unduly burdensome and wish to mitigate that consequence. In those cases, an employer can either lend the employee the money to pay taxes on the vested shares or pay a cash bonus (which itself would be taxable) to help pay the tax bill. Note that if vesting is tied to a company liquidity event, the employee would be able to sell some or all of his stock to cover the taxes.

Attaching Strings to Keep Interests Aligned

Finally, even after the restricted stock becomes vested and fully owned by the employee, there are ways to protect the interests of the majority owner(s) particularly where the company may be positioned for a sale. A classic example would be the imposition of a “drag along” right, which essentially allows the majority owner to require the grantees of restricted stock to sell their shares to whomever the majority owner sells to (so long as they get the same terms). This will assure that when the majority owner finds the right deal, his employee-shareholders won’t be in a position to impede progress on the deal. In most cases, the employees are thrilled to be a part of the deal anyway. Restricted shares often preclude sales to third parties, limit voting rights and impose other restrictions that protect the interests of the majority owner(s).

These five attributes that make restricted stock compare favorably to other forms of equity-based compensation can really be summed up in one word: simplicity. For most successful business owners that key attribute makes all the difference.