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Employment Law, Benefits & Compensation

Motivating Your Startup’s Team: Restricted Stock or Stock Options?

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There are a variety of forms that equity compensation can take, but the two most prevalent in the startup environment when the startup is a corporation are restricted stock and stock options. Many new entrepreneurs are familiar with these general concepts, but are not sure which is appropriate to issue to their employees, consultants and advisors. What follows is a high-level summary of restricted stock, stock options and the differences between the two to aid founders in understanding which is more appropriate for their team members. 

  Stock Option Restricted Stock Discussion
What is it? A contractual right to purchase shares of the company at a set price (“strike price”), which can be exercised over a specific period of time.  The current grant of shares of the company’s stock that are subject to the company’s right to repurchase the shares.  
What does the recipient pay? At grant of award, nothing. When they choose to exercise the option, they then pay the strike price for each share they choose to acquire. The recipient can either pay the current stock price for their shares, or the company can grant the shares to the recipient for free. However, the recipient must recognize income for tax purposes on the difference between the price they pay for the shares and the current value of the shares (see How is it taxed? below).  Restricted stock is a popular choice when the value of the stock is low. In an acquisition of the company, option holders might (but do not always) have the opportunity to “net exercise” their option. Very often, the option holders are “cashed out” without exercising their option (i.e., are paid the net value of their options in the transaction).
Is it transferable? An option is only transferable upon death (i.e., it is only exercisable by the holder or the holder’s estate). Once the holder exercises the option and holds shares of the company, the shares are transferable subject to securities laws, the terms of the option agreement and any restrictions in the company’s bylaws or stockholder agreements. As a practical matter, this means that there are usually very substantial restrictions on transferability.  Once vested, the shares are transferable, subject to securities laws, the terms of the restricted stock agreement and any restrictions in the company’s bylaws or stockholder agreements. As a practical matter, this means that there are usually very substantial restrictions on transferability.  
What does “vesting” mean? An option vests through more and more of the option becoming exercisable over time. An option that is 0% vested cannot be exercised, but an option that is 50% vested can be exercised as to 50% of the shares covered by the option. Vesting refers to the company’s right to repurchase the shares at the lower of the original issuance price or fair market value at the time of repurchase, which right lapses over time. The right of repurchase is triggered by the holder of the restricted stock ceasing to be a service provider to the company. If the holder leaves the company when his/her shares are 50% vested, the company then has the right to repurchase the 50% which remain unvested back from the holder at the lower of the original issuance price or fair market value at the time of repurchase.  The most common vesting schedule for both types of awards is a 4-year monthly vesting schedule with a one-year “cliff” (i.e. 25% of the shares vest on the one-year anniversary of the award, then 1/48 of the shares vest monthly for the remaining three years).
Can the holder vote? No right to vote until the option is exercised. Has the right to vote all of the shares, even those which have not yet vested. Both options and restricted stock are dilutive to the company’s cap table on a fully-diluted basis, but options are not dilutive to stockholders’ voting percentages until exercised. 
How is it taxed? Not taxed at grant of option. Whether the option is taxed at exercise depends on whether the option is an incentive stock option (ISO) or nonstatutory stock option (NSO). With an NSO, the spread between the exercise price and the fair market value of the underlying stock at exercise is subject to tax as compensation. With an ISO, this spread is not subject to ordinary income tax, but it is an alternative minimum tax preference item. Restricted stock is taxed on the difference between the value of the stock granted to the recipient, and the amount the recipient paid (if any) for the stock. This spread is taxed as ordinary (compensation) income. The default rule is that each share of restricted stock is taxed in this manner when it vests. However, the holder can make a Section 83(b) election to accelerate the tax, so that the holder recognizes ordinary income equal to the difference between the value of the stock and the amount paid for the stock (if any) at the grant date. Then any future appreciation or depreciation is taxed as capital gain/loss at the time the shares are sold, assuming holding period requirements are met.  If a restricted stock award will result in a hefty tax bill for the recipient, the company can soften the impact with a cash bonus; however, cash bonuses are also taxable, so companies will sometimes “gross up” such a bonus, meaning they will increase the gross amount of the cash bonus to account for the taxes that must be withheld from the payment.
What happens when they leave the company?

An employee holding an ISO has 90 days in which to exercise any vested portion of their option after their employment terminates (or 12 months to exercise upon death or disability). The company can set the terms of an NSO, but frequently the 90-day window is still used.

The company has the right to purchase any unvested shares back from the holder at a price per share set in their restricted stock agreement (typically the lesser of the amount originally paid for the shares or their then-current fair market value). The company may also have the right to repurchase the vested shares at fair market value.

 

For additional insight on the forms of equity awards available to your team, feel free to comment below, email me or connect with me on LinkedIn

The blog content should not be construed as legal advice.

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