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Restricted Stock

An award of stock to an individual that is subject to conditions before they can be sold or transferred

What is Restricted Stock?

Restricted stock refers to an award of stock to a person, subject to conditions that must be met before the stockholders can have the right to transfer or sell the stocks. It is issued to corporate officers such as directors and senior executives, and is non-transferrable until certain conditions have been met. Some of these conditions may include continued employment for a defined period, earnings per share goals, or other pre-agreed financial performance goals. The issuing company then transfers the stocks to the grantee after all the conditions have been met.

 

Restricted Stock

 

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.

 

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 to 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.

 

Enforce non-compete agreement

The buyer may also award restricted stocks 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 period.

 

Restricted stock units vs. restricted stock awards

Restricted stock units and restricted stock awards are two of the most popular stock bonus structures for employees. Here is an explanation of how the two stock variations compare to each other.

 

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 an agreed period before they can get the full rights to the stocks.

Sometimes, restricted stocks for high-level executives may be tied to performance goals either at the individual or corporate level. The employee may choose to receive cash that equals the total value of the stocks awarded. Also, the holders of these stocks do not enjoy voting rights. They only obtain voting rights when the stocks are exercised and become actual stocks of the company with the right to sell and transfer.

 

Restricted stock award

Restricted stock awards share a lot of similarities with restricted stock units. Companies use these awards to grant employees company stocks, in addition to their regular compensation. One of the features that differentiate restricted stock awards from restricted stock units is that the former come with voting rights immediately when they are awarded.

However, the employee cannot redeem the restricted stock awards for cash, as is the case with restricted stock units.

 

Restricted stocks vs. stock options

Employees typically prefer owning restricted stocks 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 stocks. This is because, when the restricted stock vests, the employee automatically become owners of the company and are entitled to vote during special and annual general meetings. It gives employees an entitlement of ownership, and they focus more on achieving the overall corporate goals of the company.

On the other hand, owning stock options does not give employees a sense of entitlement. The only way an employee gets to benefit from their years of hard work at the company is when there is an increase in stock prices so that they can cash out. The employees then focus on short-term activities that can raise the stock prices 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 stocks. If stock prices decline, holders of stock options lose 100% of the value of the options. This is in contrast with restricted stocks that retain some intrinsic value regardless of stock price movement.

 

Taxation of restricted stock

Restricted stock is considered gross income in regards to taxation. Furthermore, this income is recognized on the vesting date of the stocks. The vesting date is the date on which the stocks can be transferred.

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.

A holder of restricted stocks 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 to the IRS. This requires the tax to be paid before the vesting date. This helps minimize the amount of tax liability if the stock is granted at a lower price. However, this action is risky because, if the restricted stocks do not vest, the taxes paid are non-refundable.

 

Related readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

  • Cliff Vesting
  • Employee Stock Ownership Plan (ESOP)
  • Remuneration
  • Stock-based Compensation

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