Restricted Stock vs. Stock Options: Deciding How to Compensate your Employees

Fotolia_180008799_Subscription_Monthly_M-300x200Startup companies often use stock options to attract new quality talent. If you have decided to do so, there are some special considerations when deciding the best approach to compensate your employees. Two common approaches include restricted stock and stock options.

What is Restricted Stock?

Restricted stock is a stock plan that gives particular employees a right to purchase stock shares. These restricted shares may be at a discounted value, fair market value, or even at no cost. Despite the right to buy the restricted stock, the shares are not actually owned by the employee until a particular triggering event occurs. For example, a company may restrict the transfer of the stock until a particular amount of time has elapsed (e.g., three years from the date of hire). Another example would be a condition regarding company performance (e.g., $1m in gross revenue). The employee then takes possession after the triggering event occurs, thereby lifting the “restriction” on the stock.

What are the Benefits of Restricted Stocks?

Offering employees restricted stock can be beneficial for a company. First, if there is a time duration before a stock option vests, then it may incentivize the employee to stick around for a while. This can help limit turnover and help ensure work continuity. Second, an employee may gain some tax benefits after the restricted stock vests if they make a Section 83(b) election. This is an IRS election that must be made within 30 days of acquiring the restricted stocks.

What is a Stock Option?

Some companies provide their employees with outright stock options, which differ from restricted stock. This can be very popular for startup companies that are cash-poor. Generally, the price of the stock is equal to the market value (if publicly traded) at the time the option is exercised. However, there can be exceptions. In a private company, the stock is typically based on the last funding round share price. Employees can then sell the stock and gain a profit if the value goes up.  Thus, the employee banks the difference between the price that the stock option was promised to them at, and the price at which they sell it.

There are generally some rules that govern these stock options. There may be a maximum period of time during which a stock option can be exercised. Ten years is common. In other situations, such as an option grant, a share may vest after one year. There are also staggered situations, for example, 25% vests after year 1, 25% after year 2, etc. Also, when you can buy and sell stock, depending on your role at the company, may be subject to federal regulation.

What are the Benefits of a Stock Option?

Stock options can help attract quality candidates. These stock options can have great value in the form of a big “payday” if the stock price soars. For example, a stock option given at a price of $5 per share becomes very valuable if the stock price soars to $40 per share. A new employee that is given 2,000 shares (at $5 each) in this scenario would have a net gain of $70,000.

Contact the Structure Law Group to Discuss Stock Options for your Employees

At the Structure Law Group, we advise San Jose businesses on a wide variety of matters, including how to best structure stock options for your employees. There can be broad tax implications and internal costs when you offer stock. It is important to be well-informed on these issues before offering any type of security. Contact us today at 408-441-7555 or email through our online contact form.

 

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