Restricted Stock and Restricted Stock Units: How They Work

An award, or promise of an award, of company stock that is subject to conditions before the stock can be sold or transferred

What is Restricted Stock?

A restricted stock award (RSA) refers to an award of stock to a person who is subject to conditions that must be met before the stockholder has the right to transfer or sell the stock. It is commonly issued to incentivize 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. These 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 Stock

What are Restricted Stock Units?

Restricted stock units (RSUs) are similar to restricted stock but have some key differences. RSUs represent a contractual promise to deliver shares to an employee, or potentially even a cash payment in lieu of shares.

The restricted stock units are issued on a vesting schedule, and the employee must continue working with the company for a specified period of time before the employee can get the full rights to the shares. Sometimes, RSUs for high-level executives may be tied to specific performance goals instead of a time-based vesting schedule.

In contrast, an award of restricted stock means that actual shares are delivered to the employee, but there are limitations on transferability and selling the restricted shares. Additionally, restricted stock usually includes voting rights, whereas RSUs do not. Finally, the employee cannot usually redeem restricted stock awards for cash, in contrast to some RSUs.

Key Highlights

  • Restricted stock is a form of equity consideration given to key employees. Restricted stock units are similar to restricted stock but differ in a couple of details.
  • Restricted stock awards or restricted stock units are given to incentivize employees so they will focus on achieving the overall, long-term goals of the company, since the employees are (or will be) equity owners of the business.
  • Restricted stock is somewhat similar to employee stock options, with the biggest difference being that employees have to pay for their stock options. In contrast, employees have to continue working with the company in order to receive restricted shares. in other words, there is no exercise price.

Differences from Employee Stock Options

Both restricted stock awards and restricted stock units, as well as employee stock options, are forms of employee compensation. However, restricted stock (and units) differs from stock options in a significant way: an employee is required to pay, or exercise, their stock options in order to receive the underlying shares.

This differs from restricted stock awards and restricted stock units. With restricted stock, the employee does not have to pay for the shares — the employee only has to fulfill various service or performance obligations. Assuming those obligations are met, the employee will receive the shares (the employee is vested), at which point they will become unrestricted, and the employee can sell or transfer the shares.

How is Restricted Stock Used?

Both restricted stock awards and restricted stock units are a form of equity compensation given to key employees. While both restricted stock awards (RSAs) and RSUs have been used for a long time, they have become increasingly popular, especially RSUs.

According to a recent survey, 86% of publicly traded companies in the United States grant RSUs, up from 3% in 2000. In contrast, companies offering employee stock options decreased from 100% to 47% over this same period.

Restricted Stock in a Buyer-Seller Relationship

Restricted stock 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 acquiring company if the seller meets specific post-sale transaction requirements.

Smooth Transition

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 the restricted stock award.

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.

Restricted Stock vs. Stock Options

Employees typically prefer owning restricted stock rather than stock options for several reasons, including:

Motivating Tool

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 or RSUs. 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 shares that retain some value regardless of stock price movement.

Accounting for Restricted Stock/RSU Grants

The accounting for restricted stock and RSUs 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 and RSUs is based on the fair value of the stock on the grant date. The compensation expense is then recognized over the employee’s 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 that 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

Vesting Date

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:

Vesting Date

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.

Taxation of Restricted Stock Awards

The taxation of restricted stock and restricted stock units is complex and will vary based on jurisdiction. However, there are some generalities which apply in most situations.

Restricted stock awards are considered ordinary income with regard to ordinary income tax. Furthermore, this income is usually recognized on the vesting date of the restricted stock. 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 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 restricted stock price.

The employee also pays capital gains tax on any gains in the value of the stock when it is sold.

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 restricted stock is granted at a low price.

However, taking this action is risky because, if the restricted stock never vests, the taxes already paid on it are non-refundable. For this reason, restricted stock is sometimes issued with no value at the grant date, eliminating any immediate tax burden.

Taxation of Restricted Stock Units

The taxation of RSUs is usually more straightforward when compared to restricted stock. Since there is no actual stock delivered on the grant date, only the vesting date matters for tax purposes (thus, the 83(b) election does not apply). The income tax treatment requires the RSU recipient to declare income in the amount of the fair market value of the stock on the date of vesting.

In practice, companies will often withhold some shares to cover the tax burden when the RSU vests. In what is known as the “sell-to-cover” strategy, the company sells just enough of the vested RSUs to cover the tax burden and then distributes the remaining shares to the employee. This results in the RSU holder receiving fewer shares. Additionally, the RSU recipient may be required to pay capital gains tax when the shares are eventually sold.

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