Restricted stock is generally awarded to a select number of top executives in a company. It is simply a grant of a number of shares of company stock with certain limitations on it. If the employee leaves the company before the stock vests, he forfeits his shares. The important terms to remember in a restricted stock grant are the number of shares and when it is received.
Once the restrictions lapse, the shares become vested. Typical restriction periods are 3-5 years; however, they can be more or less. Some grants vest all at once and others are subject to vest in tiers (i.e., one-third of the shares will vest each year for three years). The employee receives the full value of the shares at the time of vesting — not just the gain since the date of the award.
Vesting can be determined in three ways:
- At a specified date (time-based),
- When a performance target is met (performance-based), or
- Performance target is met by a certain date (a combination of 1 and 2).
Restricted stock is generally not taxed until the stock vests. At that time, the stock is treated as ordinary income to the employee.
There is, however, an option available to participants called an “83(b) election.” If this election is made within 30 days of the grant date, then the participant may pay the tax at the time the shares are issued instead of when they vest. Any increase in the stock’s value can then be taxed at the lower capital-gains rate. This method is not used frequently. However, if the participant believes there is great upside potential, then it may be worthwhile.
Besides having to come up with the money to pay the taxes in advance, another major drawback to this election is that the participant risks the chance of paying the IRS for income never received. Should he leave the company and forfeit the stock prior to vesting, he is not entitled to any refund of taxes previously paid.
Once the grant is made, the employee owns the stock outright. He can vote the stock and receive dividends.
As a recruitment and retention tool, restricted stock can be of value to an organization.
The employee can never lose because the share price never falls below zero, and the company uses the grant as a “golden handcuff.”
Restricted stock vs. stock option
Restricted stock usually retains some value — unlike a stock option which can become useless if the stock price falls below the strike price (the price on the date it was granted). Employees may be awarded fewer shares of restricted stock than stock options, but they are much less risky. In addition, the immediate ownership rights of those holding restricted stock is not given to those who have been granted stock options. Until the options are vested and purchased by the employee, they do not have ownership rights to the stock. While some companies have already reduced equity-based compensation over the last few years, the movement is accelerating because of an accounting rule that requires companies to count stock options as expenses. These are a few of the major differences between the two types of long-term incentive awards being used by companies.