Restricted Stock

Stock in a firm subject to limitations and requirements, is not wholly transferable to the insider, and cannot be sold before it vests.

Author: David Bickerton
David Bickerton
David Bickerton
Asset Management | Financial Analysis

Previously a Portfolio Manager for MDH Investment Management, David has been with the firm for nearly a decade, serving as President since 2015. He has extensive experience in wealth management, investments and portfolio management.

David holds a BS from Miami University in Finance.

Reviewed By: Christy Grimste
Christy Grimste
Christy Grimste
Real Estate | Investment Property Sales

Christy currently works as a senior associate for EdR Trust, a publicly traded multi-family REIT. Prior to joining EdR Trust, Christy works for CBRE in investment property sales. Before completing her MBA and breaking into finance, Christy founded and education startup in which she actively pursued for seven years and works as an internal auditor for the U.S. Department of State and CIA.

Christy has a Bachelor of Arts from the University of Maryland and a Master of Business Administrations from the University of London.

Last Updated:September 30, 2023

What is a Restricted Stock?

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

The stock is no longer restricted and can be transferred to the award recipient whenever those requirements are met. 

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 the vesting period. Letter stock and section 1244 stock are other terms for restricted shares.

Due to favorable accounting regulations and income tax treatment, RS is a well-liked substitute for stock options, especially among executives.

How Restricted Stock Works

Employees who own restricted shares have a stake in their company, but they are worthless before vesting. Employees that perform well and stick with a company are incentivized to do so by vesting, which grants the employees rights to employer-provided assets over time. 

When employees fully own an asset, it is determined by a company's vesting schedule (in this case, RSU). The restricted stock units are given a fair market value at the moment of vesting.

In the middle of the 2000s, these stocks gained popularity due to the requirement for businesses to expense stock option grants. 

When RS is used as a form of employee compensation, certain conditions must be met for it to become transferable.

The conditions are:

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

RS is awarded to employees during mergers and acquisitions to ensure that the shares are not sold before they become vested and, as a result, prevent any harm from being caused to the business.

If an executive leaves the company and fails to meet corporate or personal performance targets or violates SEC trading regulations, they may be forced to surrender the stock. 

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 amount of capital the firm needs to operate, 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. For example, if the firm is bought by another firm and the employee is laid off during the subsequent reorganization, the employee's shares become unrestricted.

Restricted Stocks in a Buyer-Seller Relationship

These stocks can be used as a form of payment to the business's seller if the required post-sale transaction is completed. The buyer can then transfer the unregistered shares to the seller.

1​​​. A seamless transition

One of the requirements could be that the management team from the seller's side stays with the company for a predetermined amount of time. 

This facilitates a smooth transition for the new management team from the buyer's side into the new company. The buyer may decide not to grant the RS if any of the executives leave before the predetermined period.

2. 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 the special tax elections that are usually associated with RSUs, because when an RSU is awarded, no company stock is given; but, when an RSA is given, the stock is awarded to the employee.

1. 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 the time of distribution comes, employees can take their RSUs as cash with a value equal to the shares.

2. Restricted Stock Awards

RSAs are similar to bonuses awarded to the employee, subject to a vesting timeline. However, unlike RSUs, RSAs are not considered a part of a long-term payment plan. Furthermore, no Special Tax 83(b) elections are made at the time of the grant.

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

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,  provide shares outright and shareholder rights and benefits. 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:

Comparable Company Analysis (comps)
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 the restricted shares is preserved even if their price falls. As a result, it is valuable. The stocks must be exercised before the expiration date; otherwise, they will be worthless.
When you sell your shares and make a profit, you may be subject to capital gains tax. It is worth noting that the value of the shares determines the value of 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, this revenue is realized on the stock vesting date. 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 entire stock value. In addition, when the stock is sold, any increase in value is also subject to capital gains tax, which the employee pays. 

In the same year of selling the RS, the employees should pay capital gains tax on any future appreciation or depreciation in the value of that stock., in addition to paying income tax on the value of restricted stocks the year it vests.

By exercising section 83-B election, the RS holder can determine his tax liability on the date of acquisition rather than the date the stock vests.

RSUs have no monetary value until they vest, but they give employees a stake in the company. The RSUs are given a fair market value (FMV) when they grant. 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 more minor impact than stock options since fewer shares are typically issued, and there is typically less of a discount for illiquidity.  

There are a few considerations when valuing RSUs:

1. Stock price

The RSU holder receives shares in the firm (or cash equivalents) upon vesting, and they are 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. But other factors might significantly raise or lower this initial figure.

2. 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 price volatility of the stock, which is the measure of the variance of stock prices over time.

3. 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 a part of the shares (or cash equivalents) may be held back to cover income taxes. 

Therefore, while determining the value of the RSU, the employee's income tax rate may be a crucial factor. 

4. 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).

5. 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, any future earnings must be reduced to reflect the time value of money.

Key Takeaways

  • Employees who receive restricted securities as part of their executive salary are given non-transferable shares with restrictions on when they can sell them.
  • The restrictions include a vesting period that might go on for several years, assuming the employee stays on board the business for the required period or until a specific company milestone is reached.
  • This stock is most frequently used by well-established businesses that wish to inspire staff by giving them a stake in the company's success.
  • RSA and RSU are two examples of RS offered by companies, specifically startups, for employees.
  • By considering restricted stock awards as issued and outstanding shares, restricted securities are included in a company's equity valuation.
  • The revenue that an investor gets when he sells an investment is subject to the capital gains tax (CGT). Regular income tax rates apply to short-term capital gain. However, long-term capital gains taxes are due if the transaction happens more than a year after the vesting date.
  • The market value of the shares at the time of vesting determines your taxable RSU income, which is subject to usual income tax.
  • The special tax elections frequently included with RSUs are unavailable to employees receiving RSAs.

Researched and authored by Sara Nasrallah | LinkedIn

Reviewed and Edited by Purva Arora | LinkedIn

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