Restricted stock refers to an award of stock to a person that is subject to conditions that must be met before the stockholder can exercise the right to transfer or sell the stock. It is commonly issued to corporate officers such as directors and senior executives.
Some of the conditions may include continued employment for a defined period, earnings per share goals, or other pre-agreed financial performance goals. The conditions may apply to the awarding of stock rather than the right to sell or transfer stock that has already been awarded to the grantee.
Restricted Stocks in a Buyer-Seller Relationship
Restricted stocks may be used as part of the consideration between a buyer and a seller. The buyer of a business may award the seller restricted stock in the company if they meet specific post-sale transaction requirements.
One of the requirements may involve ensuring that the management team from the seller’s side remains in the business for an agreed duration of time. This helps the new management team from the buyer’s side adapt to the new business with ease. If any of the executives leave before the agreed period, then the buyer can cancel awarding the restricted stock.
Enforce non-compete agreement
The buyer may also award restricted stock to the management team as a way of enforcing a non-compete agreement. The new buyer wants the seller’s assurance that after buying the business, the seller will not venture into an identical business model that competes directly or indirectly with the buyer. The restricted stock becomes transferable after the expiration of an agreed-upon period of time.
Units vs. Awards
Restricted stock units and restricted stock awards are two of the most popular stock bonus structures for employees.
Restricted stock unit
A restricted stock unit refers to a promise to an employee to grant them a specific number of shares in the employing company. The stocks are issued on a vesting schedule, and the employee must continue working with the employer for a specified period of time before they can get the full rights to the stocks.
Sometimes, restricted stock for high-level executives may be tied to performance goals either at the individual or corporate level. The employee may have the option to choose to receive cash that equals the total value of the stock rather than receive the actual stock. Also, the holders of this type of stock do not typically enjoy voting rights.
Restricted stock award
Restricted stock awards share a lot of similarities with restricted stock units. Companies use these awards to grant employees company stock in addition to their regular compensation. One of the features that differentiate restricted stock awards from restricted stock units is that the former comes with voting rights immediately when awarded.
However, the employee cannot usually redeem restricted stock awards for cash, in contrast to the case with restricted stock units.
Restricted Stock vs. Stock Options
Employees typically prefer owning restricted stock rather than stock options for several reasons, including:
Employees are motivated to act and think like owners of the company when they are awarded restricted stock. This is because, when the restricted stock vests, the employee automatically becomes a part-owner of the company and is entitled to vote during special and annual general meetings. Hopefully, this motivates employees to focus more on achieving the overall corporate goals of the company.
In contrast, owning stock options tends more to make employees focus on short-term activities that can raise the stock price for short-term gains, rather than focusing on long-term gains that will help the company grow.
Stock options can easily become worthless
Stock options come with a high possibility of becoming worthless, as compared to restricted stock awards. If the stock price remains below or declines to below the option exercise price, then the option is essentially worthless, as the option holder cannot profitably exercise the option. This is in contrast to restricted stocks that retain some intrinsic value regardless of stock price movement.
Accounting for Restricted Stock/RSU Grants
The accounting for restricted stock awards can be quite technical. For example, if actual shares are delivered to the employee, then journal entries would impact equity. If the value of the shares is paid in cash, then the company would most likely record a liability.
In general, future compensation expense related to restricted stock grants is based on the fair value of the stock on the grant date. The compensation expense is then recognized over the employees’ service/vesting period.
The following journal entries assume shares are actually delivered to the employee and are not cash-settled. At the time the restricted stock award is granted to the employee assume the fair value of the restricted stock is $100,000. Further assume the 25% of the grant vests annually over the next four years.
The journal entries might look something like this:
At Grant Date
Debit Contra-Equity Account $100,000
Credit Common Stock and APIC $100,000
Debit Stock-based Compensation Expense $25,000
Credit Contra-Equity Account $25,000
However, if accounting rules do not allow the presentation of a contra-equity account, then common stock and APIC may only show the vested portion. This would change the entries to the following:
Debit Stock-based Compensation Expense $25,000
Credit Common Stock and APIC $25,000
Essentially, the grant date entry would not be recorded in the company’s books, but the information is still necessary in order to estimate the stock-based compensation expense.
Restricted stock is considered gross income in regard to taxation. Furthermore, this income is recognized on the vesting date of the stocks. The vesting date is the date on which the stock can be transferred or sold by the grantee.
An employee pays income tax on the total value of the stock during the period in which it vests. The employee also pays capital gains tax on any gains in the value of the stock when it is sold. The amount of restricted stock that an employee is required to declare for tax purposes is the fair market value of the stock, minus the original exercise price.
However, in the United States for example, a holder of restricted stock may exercise a Section 83(b) election that allows him/her to use the price on the grant date rather than the vesting date price to calculate the amount of income tax due. This requires the tax to be paid before the vesting date, but helps minimize the amount of tax liability if the stock is granted at a lower price. However, taking this action is risky because, if the restricted stock never vests, the taxes already paid on it are non-refundable.