Restricted stock (sometimes referred to as RSAs) is a common form of equity compensation in early stage startups. This article will help founders understand the advantages and disadvantages of restricted stock, as well as understand whether it’s right for you. Of course, every situation is unique, so it’s best to consult with an attorney before making any decisions. If you’re looking for legal counsel, feel free to reach out to us here.
Restricted stock is a grant of common stock to a startup. It is often granted to founders or employees instead of or in addition to cash salaries. There are two main restrictions on restricted stock:
- Vesting: Those who receive restricted stock typically earn their stock over time.
- Transfer: Recipients cannot sell or transfer their shares except under certain conditions set out in the restricted stock agreement.
Advantages and Disadvantages of Offering Restricted Stock to Employees
Restricted stock is a useful tool for startups that want to attract and retain talented employees. Here are some reasons why:
- Motivation: Offering restricted stock can increase employees’ investment in the company’s success. They have a personal stake in the company’s growth, which can motivate them to work harder and stay with the company longer.
- Retention: Restricted stock can be used to incentivize employees to stay with the company for a certain period of time. This can help reduce employee turnover and save costs associated with hiring and training new staff.
- Tax Benefits: Restricted stock can offer tax benefits for the employee.
However, there are also potential downsides to keep in mind:
- Liquidity Risk: Because restricted stock is subject to restrictions on sale or transfer, it may not provide immediate liquidity for employees. This could be a problem if an employee needs cash quickly or if they are unable to sell their shares due to market conditions.
- Administrative Burden: Administering restricted stock plans can be complex and time-consuming. This includes tracking vesting schedules, ensuring compliance with regulations and communicating with employees about their equity compensation.
- Dilution: Offering equity compensation through restricted stock can dilute existing shareholders’ ownership percentage in the company. This can potentially impact control over decision-making processes or future fundraising efforts.
How to Structure a Vesting Schedule for Restricted Stock
In a restricted stock grant, shares are granted to an employee based on their performance over time. This is known as a vesting provision, which gives the company the right to repurchase the shares. The company issues the total number of shares to the employee but reserves the right to repurchase those shares. As the employee meets vesting milestones, the company’s right to repurchase a portion of the shares is removed until the employee fully owns all the shares in the equity award.
When it comes to structuring a vesting schedule for restricted stock, there are several factors to consider. Here are some key considerations:
One approach is to tie the vesting of restricted stock to company milestones or performance targets. This can incentivize employees to work toward specific goals and help align their interests with those of the company.
However, the most common approach is time-based vesting, where shares gradually become vested over a set period of time. This can be structured in different ways, such as monthly, quarterly or annually. The most common startup vesting schedule is a four-year vesting schedule with a one-year cliff, where the shares vest monthly.
Most startup vesting schedules have a cliff, which is a date when the first tranche of stock vests. The most common cliff is one year. If the employee is on a one-year cliff, they will not vest any of their stock until the one-year mark. On the 12-month anniversary, they will vest all 12 months. The purpose of the cliff is to give the company enough time to assess the employee’s performance. If the startup hires an employee and realizes that they are not a good fit within the first year, they can terminate without that employee walking away with shares in the company.
It’s important to note that there is no one-size-fits-all approach when it comes to structuring a vesting schedule for restricted stock. Companies should consider their unique circumstances and consult with legal and financial experts before implementing any equity compensation plan. If you’re looking for legal counsel, reach out to us here.
Tax Implications of Restricted Stock
Restricted stock can have significant tax implications for employees. Here are a few key things to keep in mind:
Employees who receive restricted stock may be able to make a Section 83(b) election with the IRS. This allows them to pay taxes on the value of their shares at the time of grant rather than at vesting. By doing so, employees may be able to reduce their overall tax liability if the value of the company’s shares increases significantly over time. If you want to learn more about the 83(b) election, click here.
Taxation at Grant or Vesting
With restricted stock, employees generally pay taxes on the value of the shares at the time of grant or vesting (depending on whether they opt for an 83(b) election). This means that even if an employee has not yet sold their shares, they may still owe taxes on them.
Alternative Minimum Tax (AMT)
In some cases, employees who receive restricted stock may be subject to alternative minimum tax (AMT). This is a separate tax calculation that applies to certain types of income and can result in higher tax liability for some individuals.
How to Effectively Communicate the Value and Benefits of Restricted Stock to Employees
Offering restricted stock can be a great way for startups to motivate and retain their top talent. However, it is crucial that employees understand the value and benefits of this type of equity compensation. Here are some tips for communicating the advantages of restricted stock in a clear and straightforward manner:
Transparency about how restricted stock works and what employees can expect from this type of equity compensation is important. Clear information about equity allocation, vesting schedules, restrictions on sale or transfer, and potential tax implications can help employees make informed decisions about their compensation package.
Emphasize Long-Term Benefits
Offering restricted stock encourages employees to think long-term. Highlighting the potential benefits of owning shares in a growing company over time can help employees see the value in this type of equity compensation.
Restricted stock may be a new concept to some employees, particularly if they have never worked for a startup before. Providing examples of how other companies use this type of equity compensation, as well as how it has benefited current employees, can help illustrate its value.
Offer Support and Education
Providing education and support can help ensure that employees feel confident and comfortable with their equity compensation package. This might include offering resources such as webinars or one-on-one meetings with financial experts who can answer questions about taxes or investment strategies.
How to Handle Restricted Stock in the Event of a Company Acquisition
Here are some key factors to consider when handling restricted stock during a company acquisition:
Many restricted stock agreements include a change of control provision, allowing for accelerated vesting if the company is acquired. This means that all or a portion of an employee’s unvested shares may become immediately vested upon acquisition.
Before agreeing to an acquisition, companies and employees with restricted stock should carefully negotiate the terms of any potential buyout. This includes determining whether unvested shares will be taken on by the acquiring company and at what price.
Acquisitions can have significant tax implications for both companies and employees with restricted stock. Legal and financial experts should be consulted to understand how any potential tax liabilities could impact the deal.
Communication with Employees
In the event of an acquisition, it’s important for companies to communicate clearly with employees about how their equity compensation will be impacted. This includes explaining any changes to vesting schedules, ownership rights or potential payouts.