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Restricted Stock and Restricted Stock Units: How to Design and Grant a Plan

LegalGPS : Oct. 15, 2024

14:21

Restricted stock equity compensation has become increasingly popular among corporations as a way to attract and retain top talent. In this guide, we will cover what restricted stock equity compensation is, the different types of plans available, and the steps to design and implement a restricted stock plan effectively.

We'll also address key legal issues, tax considerations, and compare Restricted Stock Awards (RSAs) and Restricted Stock Units (RSUs) to help you make informed decisions when granting equity to your employees.

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Introduction to Restricted Stock Equity Compensation for Corporations

A restricted stock plan (also known as restricted stock equity compensation) is a contractual arrangement that allows recipients to acquire corporate stock and gain equity interest in the company. However, the specifics of these interests, and when they can be enjoyed, depend on the type of plan and the restrictions or conditions imposed by the employer.

The typical structure of a restricted stock plan includes four key steps:

Granting the Plan: The employer grants the restricted stock plan to recipients and imposes specific restrictions.
Accepting the Plan: The recipients decide whether to accept the plan.
Waiting for Restrictions to Lapse: Recipients may need to wait for restrictions to lapse. During this time, they may enjoy certain equity interests, such as dividends.
Full Vesting: Once the restrictions have lapsed, recipients can fully enjoy their equity interests.

There are primarily two types of restricted stock plans: Restricted Stock Awards (RSAs) and Restricted Stock Units (RSUs).

Restricted Stock Awards (RSAs)

Under RSAs, recipients receive shares at the time of grant, provided they accept the plan. However, these shares are not transferable and will be held in an escrow account by the company until specific restrictions lapse or conditions are met. In the meantime, the recipient can enjoy certain rights attached to the shares, such as voting rights and dividends. If the conditions are not satisfied, the shares in the escrow account are forfeited.

Example: If an employee receives 1,000 shares of restricted stock with a four-year vesting period, they cannot sell or transfer these shares until they fully vest. During this period, the shares are held in escrow, but the employee may receive dividends and have voting rights.

Restricted Stock Units (RSUs)

With RSUs, recipients do not receive shares at the time of grant. Instead, they receive units that can be converted into stock if specific conditions are satisfied. Unlike RSAs, RSUs do not carry voting rights or dividends before the conditions are met. However, the employer may pay dividend equivalents on the units if there is a good business reason to do so.

Example: If an employee receives 1,000 RSUs with a four-year vesting period, they will not receive the actual shares until the vesting conditions are met. Unlike RSAs, they do not have voting rights or dividends during the vesting period unless the employer pays dividend equivalents.

The growing popularity of restricted stock plans is largely attributed to two key factors:

Changes in Accounting Rules: Changes in accounting rules in 2005 required stock options to be treated as a compensation expense, reducing their appeal. Restricted stock plans, which had always been treated as such, became relatively more attractive.
Shareholder Concerns Over Dilution: Restricted stock plans often require fewer shares to achieve the same economic incentive as stock option plans, making dilution less apparent to shareholders.

Guide to Stock Options and Startup Equity

Creation of a Restricted Stock Plan

Creating a restricted stock plan involves a number of key steps that ensure the plan aligns with the company's business needs and complies with legal requirements.

Designing the Plan: The Human Resources (HR) department or relevant personnel design the plan, considering factors such as cost to the company, liquidity, tax, and accounting consequences. Input from professionals, such as legal counsel and accountants, is crucial.

Example: The HR department may decide that the goal of the plan is to retain key employees by offering equity that vests over four years. They would work with accountants to determine the financial impact and legal counsel to ensure compliance with securities laws.
Preparing Legal Documents: The company's legal counsel prepares all necessary legal documents, such as the restricted stock agreement, board resolutions, and shareholder consents.
Approval by Top Management: The finalized documents are submitted to top management for approval to ensure alignment with the company's strategic objectives.
Adoption by the Board of Directors: The plan is then submitted to the board of directors for consideration and adoption. Board approval is critical, as the issuance of stock must align with corporate governance requirements.
Shareholder Approval (If Required): In some cases, shareholder approval may be required. This is often determined by the company's bylaws.

Example: If the company's bylaws require shareholder approval for equity grants exceeding a certain percentage of ownership, the restricted stock plan must be presented at the next shareholder meeting.
Implementation: The company appoints HR or appropriate personnel to implement the plan, including distributing grant agreements to recipients and ensuring compliance with the plan's terms.

The plan should also expressly provide the board of directors with the right to amend, suspend, or terminate the plan if needed, providing flexibility in case of changes in company strategy or market conditions.

Legal Issues to Consider When Designing a Plan

When designing a restricted stock plan, companies must consider various legal issues that could significantly affect the value of the plan.

Recipients' Eligibility

There is no statutory restriction on who is eligible to participate in a restricted stock plan. A company can therefore offer equity compensation to employees, independent directors, outside consultants, advisors, and independent contractors.

However, restricted stock is often treated as securities under securities law, meaning the plan must comply with securities regulations, and companies must find proper exemptions when applicable.

Example: If a company plans to grant restricted stock to independent contractors, it must ensure that the grant complies with securities laws, such as relying on Regulation D exemptions to avoid public registration requirements.

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Amount of Stock Issued and Purchase Price

There is no statutory limit on the amount of stock that can be issued under the plan. Companies also have the freedom to determine whether recipients must pay for the stock. A private company may charge full market value for shares at the time of grant, which can help alleviate administrative burdens related to tax withholding and provide valuable cash flow.

Example: A private startup may offer restricted stock to a new executive at full market value, which is relatively low at the time of the grant. This approach provides the company with cash flow and minimizes dilution.

Vesting

Vesting refers to the process by which recipients earn ownership of restricted shares. Vesting conditions vary, but generally involve a time requirement (e.g., four years of employment) or performance milestones. Once vested, the recipient becomes the owner of the shares.

To better align interests, companies often split the total number of shares into installments, with conditions set for each year. Annual vesting is most common, though shorter intervals (e.g., quarterly or monthly) are possible.

Example: A company may grant 1,200 shares of restricted stock with a four-year vesting schedule, vesting in equal installments of 300 shares per year. This structure incentivizes the employee to stay for the entire vesting period.

Termination of Employment

If a recipient's employment is terminated before vesting, unvested equity is forfeited. If the recipient paid for the shares, the company may repurchase them at either the original price or the current fair market value, whichever is lower.

Example: If an employee leaves after two years and has only vested half of their restricted stock, the company may repurchase the unvested shares at the original grant price.

Restrictions on Vested Shares - Right of First Refusal

Even after shares have vested, companies often restrict recipients' ability to transfer them, primarily to discourage employees from leaving, retain control over who can be a shareholder, and ensure compliance with securities law. A common restriction is the right of first refusal, which gives the company the right to buy shares before they can be sold to a third party.

Example: If a vested employee wants to sell their shares, the company has the right to match the offer and purchase the shares to maintain control over ownership.

Methods of Share Payment

Most states require that shares issued under a restricted stock plan have a par value, which recipients must pay. Payment can be made via cash, check, promissory note, services, or by using treasury stock. Treasury stock is already issued stock that the company reacquires before the plan.

Example: An executive may pay for their restricted stock using a promissory note that is secured by the shares themselves. This allows the executive to participate in the equity plan without paying cash upfront.

Tax Considerations for Restricted Stock Awards (RSAs) and RSUs

Tax considerations are an important aspect of restricted stock plans, as they affect both the company and the recipient.

Tax Treatment for RSAs

For RSAs, recipients are generally required to pay tax once the shares vest. However, recipients can elect to be taxed at the time of the grant by filing an 83(b) election within 30 days of receiving the grant. If the election is made, any future appreciation will be taxed as capital gains.

Example: If an employee receives 1,000 shares at a fair market value of $1 per share and files an 83(b) election, they pay taxes on $1,000 of ordinary income. If the shares increase in value to $10 per share by the time they vest, the appreciation is taxed at the lower capital gains rate.

Tax Treatment for RSUs

RSUs are subject to Section 409A of the tax code, rather than Section 83. Recipients of RSUs are not required to pay taxes until the units are converted into shares and distributed, generally at vesting.

If a deferral election is filed, recipients can defer the distribution of stock to a future date, delaying taxes. However, while income taxes are deferred, employment taxes (FICA and FUTA) are still due.

Example: An employee receives 1,000 RSUs that vest after three years. If they defer the distribution for another two years, they will owe employment taxes at the time of vesting but defer income taxes until the shares are distributed.

A Comparison of RSAs and RSUs

Feature	Restricted Stock Award (RSA)	Restricted Stock Unit (RSU)
Stock Issuance	Issued at grant but held in escrow until vesting	Not issued until distribution
Voting Rights	Yes, before vesting	No, until distribution
Dividends	Yes, before vesting	No, but dividend equivalents may be paid
Taxation Timing	Taxable at grant (if 83(b) election is made) or vesting	Taxable at distribution
Section 83(b) Election	Available	Not available
Capital Gains Eligibility	Eligible after 83(b) election or vesting	Eligible after distribution
Flexibility for Recipients	Immediate ownership rights, subject to forfeiture	No ownership until distribution
Payment at Grant	May require payment of par value	No payment required at grant

Advantages and Disadvantages of Restricted Stock Plans

Advantages

Aligning Interests: Restricted stock plans help align employee interests with those of the company, as employees become stakeholders.
Performance Incentives: Companies have the flexibility to impose vesting conditions that ensure employees meet certain performance metrics.
Dividends and Voting Rights (for RSAs): RSAs provide recipients with voting rights and dividends, even before vesting, which can be motivating for employees.
Capital Gains Tax Treatment (83(b) Election): RSA recipients can file an 83(b) election to benefit from long-term capital gains tax treatment on future appreciation.

Disadvantages

Risk of Forfeiture: Employees may not feel that RSAs/RSUs are true compensation due to the risk of forfeiture, reducing the attractiveness of these plans.
Upfront Tax Liability (83(b) Election): Filing an 83(b) election means paying taxes upfront, which may be difficult for employees without sufficient cash.
No Dividends or Voting Rights for RSUs: RSUs do not provide dividends or voting rights before vesting, which may be seen as less beneficial compared to RSAs.

Conclusion

Restricted stock plans are an increasingly popular form of equity compensation for corporations, offering a means of aligning employee and company interests while providing financial incentives. Both RSAs and RSUs have their advantages and disadvantages, and the choice between them depends on the company's goals, the specific needs of the employees, and the company's financial and legal considerations.

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