The ABCs of Equity Compensation: Part 1 – Restricted Stock Grants
The ABCs of Equity Compensation: Part 1 – Restricted Stock Grants
May 28, 2021
The types of, tips for, and trends in restricted stock grants.

Assessing how and when you should use equity to compensate your key team members involves a variety of sometimes complex considerations. In this article, we will review the follow:

  • What is restricted stock and how does it work?
  • When does it make sense for a business to issue restricted stock?
  • Vesting schedules
  • Tax issues
  • Industry trends
Restricted Stock as Equity Compensation

When putting together a compensation package, in addition to salary and traditional benefits, equity compensation, like stock options and restricted stock, will typically be a factor for key employees and consultants. Early-stage and cash-lean companies may desire more attractive talent than they can afford, and equity compensation can help make up the difference. Companies of all sizes want to be able to reward exceptional performance and loyalty without committing to a higher salary upfront. Traditional stock options give the recipient the option to purchase a set amount of stock at some point in the future at a given price, but the recipient does not own the stock until the option is exercised. For the employee who wants to feel like they have a true ownership interest in the company, a stock option may not properly incentivize their performance. Restricted stock, however, may.

There are two forms of restricted stock: restricted stock awards (RSAs) and restricted stock units (RSUs).

  • With RSAs, the company awards the recipient with the right to purchase shares at a price per share between $0 and fair market value (FMV), subject to certain restrictions. Ownership transfers as of the grant date, and the recipient gets to retain that ownership if certain time or performance-related vesting conditions are met, but if the conditions are not met, the company can buy back the shares at a pre-set price. The recipient is a shareholder from Day 1 and has access to any shareholder rights and is subject to any shareholder responsibilities.
  • With RSUs, there is no cost upfront to the recipient aside from any taxes owed and ownership of the stock transfers over time, as the vesting conditions are met. The recipient is not a shareholder, and holds no voting power, until the first occurrence of vesting.

Both your company’s Equity Compensation Plan, which provides guidance on the types of equity compensation that can be issued and the rights and responsibilities of the company and award recipients, and the individual award agreement will detail key definitions and provisions such as company repurchase rights, termination for cause, restrictive covenants, change of control, and transferability.

Vesting Schedules that suit your goals

Your legal counsel can tailor the vesting schedule as needed to best fit your business strategy, but common vesting elements include:

  • Passage of Time – usually based on a waiting period (called a “cliff”) or duration of continuous service with the company; for example, after having been with the company for one year, the stock may vest 25% each year for the next four years.
  • Individual Performance – this individual’s job description and performance goals would influence the type of metric used.
  • Meeting Company/Department Milestones – such as the closing of a specific deal, filing an IPO, achieving a sales target, etc.
  • Combo – let your creativity shine and bundle away!

Whatever you choose, it is essential that the vesting schedule is definable, achievable, and advances your business goals. The adage “you get what you pay for” rings true, here, so think carefully about what behaviors you want to encourage and reward and whether the schedule will motivate your chosen recipient.

You down with 83(b)? Yeah, you know me!

Tax concerns in equity compensation should not be overlooked and your tax professional should weigh in on your company’s equity plan and any ancillary award agreements. The tax treatment options with RSAs and RSUs vary, so we will look at them individually.

RSAs and 83(b) Elections

Because the recipient of the RSA is paying a nominal amount for the shares, they do not owe taxes upfront unless they opt to make an 83(b) election within 30 days of the grant date. The 83(b) election allows the recipient to pay their taxes upfront on the difference between the strike price and FMV. Then, assuming they hold the stock for at least a year before selling, the increase in value at the time of selling is subject to capital gains rates, which in most cases is lower than ordinary income tax rates.

An 83(b) election can result in an increase in compensation to the recipient, but it is not without risk. In the case where the recipient has paid the taxes upfront but fails to either meet vesting conditions or the shares are otherwise repurchased by the company, and they front-loaded real tax payments on income that was only penciled-in.

Absent an 83(b) election, RSAs are taxed in the same manner as RSUs, as outlined below.

No 83(b) with RSUs

RSUs are taxed at two points: first, at ordinary income rates on the FMV of the stock when vested and second, at either capital gains rates or ordinary income rates (depending on the length of time you have held the stock) on the difference between the FMV and sale price when sold.

Which to choose — RSAs or RSUs?

Your business stage and strategy should inform your choice, alongside the recipient’s performance goals. Along with consultation from your accountant and attorney, strategic considerations should include:

  • What potential value does this person bring to the company?
  • What is the FMV of your stock and do you anticipate growth in the short/long-term?
  • If your company is private, do you have an exit strategy or market for your shares?
  • What tax treatment is more advantageous to your recipient? To the company?
What’s trending?

In the wake of a most uncertain year, companies in 2021 and beyond are looking more towards equity compensation as a way to bolster compensation packages while keeping salaries low. Conversely, employees may be wary of signing on for less certainty and may value higher salaries in lieu of worthless options. Restricted stock provides a bit of a balance between the two, giving your employees a sense of ownership and pride in their business and in many cases, short-term value that is tangible.

Developing a well-rounded and flexible Equity Compensation Plan with your legal counsel will keep you prepared for almost any eventuality and allow you to develop a compensation strategy that will motivate your team and take your company to the next level!

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This blog was written by Hunter Business Law Attorney Haley Lemon.

DISCLAIMER: This blog is for educational purposes only and does not offer nor substitute legal advice. Additionally, this blog does not establish an attorney-client relationship and is not for advertising or solicitation purposes. Any of the content contained herein shall not be used to make any decision without first consulting an attorney. The hiring of an attorney is an important decision not to be based on advertisements or blogs. Hunter Business Law expressly disclaims any and all liability in regard to any actions, or lack thereof, based on any contents of this blog.

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