Restricted Stock: Definition, Types & How It Works

Restricted stock refers to an award of stock to a person that is subject to conditions that must be met before the stockholderStockholders EquityStockholders Equity (also known as Shareholders Equity) is an account on a company's balance sheet that consists of share capital plus can exercise the right to transfer or sell the stock. It is commonly issued to corporate officersCorporate StructureCorporate structure refers to the organization of different departments or business units within a company. Depending on a company’s goals and the industry such as directors and senior executives. Some of the conditions may include continued employment for a defined period, earnings per shareEarnings Per Share (EPS)Earnings per share (EPS) is a key metric used to determine the common shareholder's portion of the company’s profit. EPS measures each common share's profit goals, or other pre-agreed financial performance goals. The conditions may apply to the awarding of stock rather than the right to sell or transfer stock that has already been awarded to the grantee.

Restricted stocks in a buyer-seller relationship

Restricted stocks may be used as part of the considerationConsiderationThe term “consideration” is a concept in English law that refers to the price paid in exchange for the fulfillment of a promise. Its main characteristic is that the promissor must give a promise of something that is of value, and the promisee must give something of value in exchange. In simple terms, anything of value that is promised by one party to another can be viewed as a consideration. between a buyer and a seller. The buyer of a business may award the seller restricted stock in the company if they meet specific post-sale transaction requirements.

Smooth transition

One of the requirements may involve ensuring that the management team from the seller’s side remains in the business for an agreed duration of time. This helps the new management team from the buyer’s side adapt to the new business with ease. If any of the executives leave before the agreed period, then the buyer can cancel awarding the restricted stock.

Enforce non-compete agreement

The buyer may also award restricted stock to the management team as a way of enforcing a non-compete agreementNon-Solicitation AgreementA non-solicitation agreement is a contract that restricts an individual (typically a former employee) from soliciting employees or customers after. The new buyer wants the seller’s assurance that after buying the business, the seller will not venture into an identical business model that competes directly or indirectly with the buyer. The restricted stock becomes transferable after the expiration of an agreed upon period of time.

Units vs. Awards

Restricted stock units and restricted stock awards are two of the most popular stock bonus structures for employees. Here is an explanation of how the two stock variations compare to each other.

Restricted stock unit

A restricted stock unit refers to a promise to an employee to grant them a specific number of shares in the employing company. The stocks are issued on a vesting schedule, and the employee must continue working with the employer for a specified period of time before they can get the full rights to the stocks.

Sometimes, restricted stock for high-level executives may be tied to performance goals either at the individual or corporate level. The employee may have the option to choose to receive cash that equals the total value of the stock rather than receive the actual stock. Also, the holders of this type of stock do not typically enjoy voting rights.

Restricted stock award

Restricted stock awards share a lot of similarities with restricted stock units. Companies use these awards to grant employees company stock in addition to their regular compensation. One of the features that differentiate restricted stock awards from restricted stock units is that the former comes with voting rights immediately when awarded.

However, the employee cannot usually redeem restricted stock awards for cash, in contrast to the case with restricted stock units.

Restricted stock vs. stock options

Employees typically prefer owning restricted stock rather than stock options for several reasons, including:

Motivating tool

Employees are motivated to act and think like owners of the company when they are awarded restricted stock. This is because, when the restricted stock vests, the employee automatically becomes a part-owner of the company and is entitled to vote during special and annual general meetings. Hopefully, this motivates employees to focus more on achieving the overall corporate goals of the company.

In contrast, owning stock options tends more to make employees focus on short-term activities that can raise the stock price for short-term gains, rather than focusing on long-term gains that will help the company grow.

Stock options can easily become worthless

Stock options come with a high possibility of becoming worthless, as compared to restricted stock awards. If the stock price remains below or declines to below the option exercise price, then the option is essentially worthless, as the option holder cannot profitably exercise the option. This is in contrast to restricted stocks that retain some intrinsic value regardless of stock price movement.

Taxation

Restricted stock is considered gross income in regard to taxation. Furthermore, this income is recognized on the vesting date of the stocks. The vesting date is the date on which the stock can be transferred or sold by the grantee.

An employee pays income tax on the total value of the stock during the period in which it vests. The employee also pays capital gains tax on any gains in the value of the stock when it is sold. The amount of restricted stock that an employee is required to declare for tax purposes is the fair market value of the stock, minus the original exercise price.

A holder of restricted stock may exercise a Section 83-B election that allows him/her to use the price on the grant date rather than the vesting date price to calculate the amount of income tax due. This requires the tax to be paid before the vesting date, but helps minimize the amount of tax liability if the stock is granted at a lower price. However, taking this action is risky because, if the restricted stock never vests, the taxes already paid on it are non-refundable.

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