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 it 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 stocks in a buyer-seller relationship
Restricted stocks may also 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 remain in the business for an agreed duration of time. It 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 the non-compete agreement. The new buyer wants the seller’s assurance that after buying off the business, the seller will not venture into an identical business model that competes directly or indirectly with the business. The restricted stock becomes transferable after the expiration of the agreed period, during which the seller honored the agreement.
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 by an employer to grant them a specific number of shares in the company. The stocks are issued on a vesting schedule, and the employee must continue working with the employer for an agreed period in the future before they can get the full rights to the stocks.
Sometimes, the restricted stock for the high-level executives may be tied to their 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 restricted stock awards to award employees with 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 comes with voting rights immediately they are awarded.
It is because the employee takes ownership of the stocks immediately they are granted to him/her. 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 prefer owning restricted stocks than stock options for several reasons, including:
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 year of hard work at the company is when there is an increase in stock prices so that they can cash out. The employees mostly focus on short-term activities that can raise the stock prices for short-term gains, rather than focus 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 when stock prices fluctuate compared to restricted stocks. When stock prices decline, employees lose 100% of the value they could’ve gained after selling their stake. This is in contrast with restricted stocks that retain some intrinsic value when stock prices fluctuate.
For example, if the shares were valued at $100 when they were awarded, and have declined to $90 at the time of vesting, the employee only suffers a loss of 10%, while they remain with a gain of 90%.
Taxation of restricted stock
The taxation of restricted stocks is governed by Section 1244 of the Internal Revenue Code. Restricted stock is included in gross income for tax purposes, and it is recognized on the date when the stocks become transferrable (also known as vesting date).
An employee pays income tax on the total value of the restricted stock in the period in which it vests. The employee also pays capital gains tax on any gains or losses in the value of the stock in the year 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. It requires the tax to be paid before the vesting date, which 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.
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: