Wednesday, January 14, 2009

Restricted Stock: a Superior Alternative to Stock Options?

A colleague (thanks Seth) recently asked whether we should recommend a restricted stock program to our start-up company client instead of an option plan. His question was a good one and bears some consideration.

Technology and other early stage companies frequently use stock options to compensate their officers, directors and other key personnel. Options are popular because they do not require free cash to issue, they are easily granted and they align the interests of the exec with a Company’s long-term success. However, in light of the recent period of depressed equity prices, many option grants are ‘underwater.’ Further, the violent gyrations in equity and debt markets make it difficult to fix baseline valuations for new option grants.

Restricted stock is actual stock (as opposed to an option, which is just a right to acquire shares of stock in the future), so it gives an executive ‘skin in the game’ and aligns the exec’s interests with his or her company. Further, shares of restricted stock are never “underwater” because the shares are fully issued at the time of grant.

Shares of restricted stock are almost always subject to vesting provisions of some sort, which encourages the exec to remain with the company and work to maximize the company’s value. For example, the vesting could be tied to the passage of time, the achievement of certain milestones, or both. A simple outline of a time-based vesting scheme could be:

• the company grants shares of restricted stock to the exec and, simultaneously, they enter into a separate agreement, which contains the vesting provisions;

• the agreement gives the company the right to repurchase the shares of restricted stock from the exec at par value (or some other insignificant price); and

• the company’s repurchase right sunsets over time (i.e. the company's repurchase right expires with respect to 25% of the shares each year, over four years).

Of course, before an early stage company issues restricted stock as equity compensation, it should consider the tax consequences. With restricted stock grants, the exec is eligible to file an “83(b) Election” under Section 83 of the Internal Revenue Code and thus obtain capital gains treatment for appreciation in the value of restricted stock. However, if this election is made, the exec must include the fair market value of the restricted stock in his or her income for that taxable year. This could be a problem if the exec does not have available cash for this additional tax burden. The company’s tax consequences will mirror those of the exec and thus largely depend on whether the exec decides to file an 83(b) Election. (Note that, as always, I urge anyone to get proper tax advice before issuing any sort of equity.)

In sum, it may make sense for an early stage company to consider issuing shares of restricted stock instead of stock options.

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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.