The Basics of Equity Compensation

Restricted Stock

While stock options give an employee the right to buy shares at a certain price in the future, they do not confer ownership in the company. On the other hand, restricted stock is a grant of shares that the recipient owns on the day of grant, and they do give voting rights and ownership in the company. Restricted stock awards may be outright grants or purchased in full or in part by the employee. They are usually outright grants. Like stock options, they may have vesting requirements that need to be met before they can be sold, such as the employee staying with the company for a certain number of years or meeting some performance goal. As with stock options, vesting may be graded, all at once or hybrid.

Depending on the plan, restricted shares may become unrestricted, (shares can be sold before vesting) if there is a change of control and an employee with restricted stock loses their job. There may also be clawback provisions tied to the grant which go into effect if an executive does not meet performance expectations or engages in activities harmful to the company that result in termination.

Restricted stock is usually granted to executives who may receive them along with other kinds of equity compensation such as stock options and stock appreciation rights. They carry less risk because unlike stock options which could end up underwater, restricted stock will almost always have some value.

Taxes

The IRS allows two methods for paying taxes on restricted stock:

1. An 83(b) election where ordinary income tax is paid at the time of the grant on the income gain from acquiring the shares. An employee paying for the shares in full has no income gain and therefore no tax. If the company pays for part of the grant, or the grant is free to the employee, taxes are paid on the gain to the employee.
2. Excluding any portion paid for by the employee, ordinary income tax is paid on the entire value of the shares when they vest.

The 83(b) election carries some risk. If the employee loses their job before the stock vests, they may have paid a tax they cannot recover on an asset they no longer own. Also, the price of the shares could drop between the grant date and date when the shares are fully vested. In this scenario, the ordinary income tax paid at grant would be higher than if the tax were paid when the shares vest.