Restricted Stock

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Last Updated:April 23, 2024

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What is a Restricted Stock?

Restricted stock, also known as restricted security or unregistered share, is stock in a firm subject to limitations and requirements. It is not wholly transferable to the insider and cannot be sold before it vests.

Once the requirements are met, the restrictions on the stock are lifted, allowing it to be transferred to the award recipient, subject to any remaining conditions or holding periods.

When used in employee compensation, restricted securities usually become transferable (or "vests") upon fulfilling specific requirements.

These include sustained employment for a predetermined period of time or accomplishment of specific product-development milestones, earnings-per-share targets, or other financial objectives.

The restrictions discourage early selling, which might harm the firm. Restricted securities often become available for sale after several years of vesting. Letter stock and section 1244 stock are other terms for restricted shares.

Due to favorable accounting regulations and income tax treatment, restricted stock (RS) is sometimes favored over stock options, especially among executives, but the preference can vary depending on individual circumstances and company policies.

Key Takeaways

Restricted stock refers to company shares subject to limitations on transferability until certain conditions are met, often used as part of employee compensation packages.
Employees are granted restricted shares, typically subject to vesting requirements based on continued employment or achievement of specific milestones, incentivizing long-term commitment and performance.
Companies utilize restricted stock to retain key personnel, align employee incentives with company performance, and prevent premature share sales, particularly during mergers and acquisitions.
Restricted stock units (RSUs) and restricted stock awards (RSAs) are common forms of restricted stock, differing in their tax treatment and ownership rights.
Restricted stock is subject to income tax upon vesting based on its fair market value, with additional taxes upon sale, although electing Section 83(b) may offer tax advantages.

How Restricted Stock Works

Employees who own restricted shares have a stake in their company but are worthless before vesting. Vesting incentivizes employees to perform well and stick with a company by granting them rights to employer-provided assets over time.

When employees fully vest in an asset, it is determined by a company's vesting schedule (in this case, RSU), but additional conditions may apply for full ownership. The restricted stock units are given a fair market value when vesting.

The restricted stock gained popularity in the mid-2000s, partly due to the requirement that businesses expense stock option grants, among other factors. When RS is used as employee compensation, certain conditions must be met to become transferable. The conditions are:

Continuing to work for a specific period
Attaining certain milestones in product development or other financial targets

Restricted Stock in Mergers and Acquisitions

The restricted stock is awarded to employees during mergers and acquisitions to prevent harm to the business and ensure that the shares are not sold before they become vested.

If an executive leaves the company and fails to meet corporate or personal performance targets or violates SEC trading regulations, depending on the terms of the restricted stock agreement, they may be subject to forfeiture of the stock.

Note

SEC Rule 144, which outlines the registration and public trading of such stocks and the restrictions on holding times and volume, outlines the SEC regulations that control restricted stock trading.

Companies provide unregistered shares to their employees to draw top talent, reduce the firm's capital, keep key personnel and leaders, and match the workforce's incentives with the company's performance.

A Fintech Startup, for example, may provide restricted shares to senior executives as an incentive without the need for immediate cash.

Furthermore, the stock may have a five-year vesting period before the executive fully owns the shares. The vesting schedule incentivizes the executive to stay longer and work towards the firm's growth.

Additionally, these shares can include a double-trigger condition, where a change in control event and an involuntary termination are required for the employee's shares to become unrestricted.

Restricted Stocks in a Buyer-Seller Relationship

If the required post-sale transaction is completed, restricted stocks may be granted to employees or executives as part of compensation or incentive plans. Let's understand the relationship below:

A seamless transition: One requirement could be that the management team from the seller's side stay with the company for a predetermined amount of time. This would facilitate a smooth transition for the new management team from the buyer's side into the new company. However, the buyer may decide not to grant the RS if executives leave before the predetermined period.
Apply a non-compete agreement: To enforce a non-compete clause, the buyer may also grant unregistered shares to the management team. The new buyer requires the seller's assurance that, after buying the company, the seller will not start a similar business that competes with the buyer directly or indirectly. After a predetermined amount of time, the restricted stock is no longer restricted and can be transferred.

Restricted Stock Units (RSUs) vs. Restricted Stock Awards

The two most common stock bonuses for employees are RSUs and RSAs. Employees who receive RSAs are not eligible for certain tax elections commonly associated with RSUs.

Unlike RSUs, RSAs involve directly awarding company stock to the employee, impacting the tax treatment. Let's understand the difference below:

Restricted Stock Units (RSUs): Employees can get RSUs issued according to a set vesting schedule. Most of the time, the employee must be employed by the business for a set period before acquiring full ownership rights to the stock. When RSUs vest, employees may receive either cash or company stock, depending on the employer's policy.
Restricted Stock Awards: RSAs are similar to bonuses awarded to employees and are subject to a vesting timeline. Similar to RSUs, RSAs are considered part of a long-term compensation plan, as they often involve vesting schedules and serve to incentivize employees over the long term. Furthermore, no Special Tax 83(b) elections are made at the time of the grant.

Note

Vesting requirements can be satisfied by time and corporate or individual achievement. Shares are typically forfeited if the receiver fails to meet the corporation's requirements before the vesting term ends.

Restricted Stock Vs. Stock Options

Restricted shares and stock options are both equity compensation, but each has specific constraints. RSUs or RSAs are examples of restricted shares. Both have vesting requirements.

RSAs, for example, grant the potential to receive shares, shareholder rights, and benefits upon vesting. Their owner is entitled to dividends and voting rights at the annual meeting.

However, the corporation may reserve the right to buy back unvested shares if the employee leaves the firm.

An employee with stock options can purchase a predetermined number of shares at a future exercise price. In addition, stock options, like restricted shares, frequently have vesting conditions.

If the employee exercises the options and the company's stock price rises above the exercise price, they may get a good profit. Here's what makes the two different from one another:

Restricted Stock Vs. Stock Options
Unregistered shares	Stock options
Actual shares of stock are issued to you for ownership depending on the vesting schedule outlined in the plan specifications.	Stock options are not a corporation's actual shares but a contract granting you the opportunity to acquire shares later.
The value of restricted shares is preserved even if their price falls, which can be advantageous in certain situations.	The stocks must be exercised before expiration; otherwise, they will be worthless.
When you sell your shares and make a profit, you may be subject to capital gains tax. The value of the shares determines the taxation on the date you purchase them.	There are three tax options: long-term, short-term on the share's growth, and as income once the shares are vested.

Taxation of Restricted Stock

RS is regarded as gross income for tax purposes. Additionally, the income tax liability for restricted stock is recognized on its vesting date, but the revenue is realized when the stock is sold. The vesting date determines the grantee's ability to transfer or sell the shares.

During the vesting period, the employee is responsible for paying income tax on the portion of the stock that vests each year based on its fair market value at the time of vesting.

In addition, when the stock is sold, any increase in value is also subject to capital gains tax, which the employee pays.

When selling the restricted stock, employees are subject to capital gains tax on any appreciation in its value after the sale. They also pay income tax on the value of restricted stock in the year it vests.

By exercising a Section 83(b) election, the RS holder can choose to pay income tax on the stock's fair market value at the time of grant, potentially reducing their tax liability compared to paying taxes at the time of vesting.

Note

RSUs have no monetary value until they vest, but they give employees a stake in the company. When they are granted, the RSUs are given a fair market value (FMV). Once vested, they are treated as income, and a percentage of the shares is deducted to cover income taxes. The remaining shares are subsequently given to the employee, who can sell them.

Valuation of Restricted Stock

Typically, RS is included in a company's equity valuation by considering RSA as issued and outstanding shares.

The market valuation of a firm with outstanding unregistered shares may be overestimated since this technique does not consider that unregistered shares have a lower value than unrestricted stock owing to the vesting rules associated with it.

However, RS has a different valuation impact than stock options due to its unique characteristics, including typically fewer shares issued and potentially different illiquidity discounts.

Considerations

There are a few considerations when valuing RSUs:

Stock price: The RSU holder receives shares in the firm (or cash equivalents) upon vesting and is free to sell these shares at any time. As a result, the stock price on the valuation date might be used as the RSU's starting point. However, other factors might significantly raise or lower this initial figure.
Expected Stock Price Volatility During the Vesting Period: Most stock values fluctuate between the valuation and vesting dates; they might go up or down. Fortunately, several notional hedging mechanisms may be used with CBVs to remove price risk between the valuation and vesting dates. When estimating the expense or benefit of employing these tactics, an essential factor to consider is the stock's price volatility, which measures the variance of stock prices over time.
Payable Taxes Upon Vesting: When an RSU is first awarded, the employee receiving it (i.e., the holder) is not subject to taxes. Instead, upon vesting, RSUs are seen as income, and some shares (or cash equivalents) may be held back to cover income taxes. Therefore, the employee's income tax rate is a crucial factor in determining the net value of the RSU after taxes.
Probability of Vesting: RSUs are distributed upon completing a certain number of service years and are awarded under a vesting schedule. Therefore, the RSUs may not vest, and any value is lost if an employee does not meet these service conditions (for instance, if they leave the firm to work for a rival).
Money's Time Value: The idea of the time value of money holds that it will be worth less in the future than now. RSUs vest over time; therefore, their present value must be discounted to reflect the time value of money.