Equity Compensation – Restricted Stock Shares, Always a Great Tool, Sometimes

Dan Walter, Performensation

Restricted
Stock Shares (RSS), often called Restricted Stock Awards (RSA) or even more simply
Restricted Stock, have been used longer than any other equity compensation
instrument. Companies have used variations of restricted stock for almost as
long as stock has existed. While ISOs
and NQSOs
are “appreciation only” awards, RSSs are Full Value Awards (FVA). RSS awards
are unique in that they require the issuance of real stock as of the date of
the award. Restricted Stock is a confusing term since it can refer to at least
three major categories of stock. 1) Stock issued prior to registration with the
SEC under the 1933 Act; 2) Stock issued to affiliates of the company who are
subject to Rule 144 filings; 3) Stock that must meet time and/or performance
conditions before it can be freely transferred. For the sake of this post, I
will only cover the last of these.

Participants
in RSS plans become instant shareholders. Most companies even provide RSS
holders with the same voting and dividend rights held by owners of unrestricted
stock. While the participants receive many of the same privileges as regular
shareholders the stock can be forfeited by the participant or repurchased by
the company if the individual does not meet their award conditions. This is
referred to as the stock being “subject to a substantial risk of forfeiture.”
This can be both a blessing and a curse to the participant.

On
the positive side, stock that is subject to a substantial risk of forfeiture
does not trigger ordinary income and associated tax withholding until the
restrictions lapse. This means the individual can control real stock without
immediate taxation. On the downside, the stock is essentially only on loan
until vesting has been achieved. If the participant leaves the company before
the shares are vested, or if performance goals are not met, the company can
usually “repurchase” the shares at the same price the individual paid for them.
Since this amount is almost always $0.00, this can be a bad deal for the RSS
holder.

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RSS
income and taxation generally falls under IRC 83. The restricted status of
these awards offers unique tax planning possibilities. Remember that a key
feature of stock
options, allows individuals to choose when to exercise their vested options
and be hit with associated income and taxes. RSS awards become taxable when
they vest. On the date of vest, the restrictions lapse and the current value
becomes ordinary income that may be subject to tax withholding. This lack of
flexibility can frighten potential participants. But, the IRS allows participants
to ignore this delayed income event by filing an 83(b) election. This election
allows income and taxes to be based on the spread at the time of award. There
are rules and restrictions regarding 83(b) elections, but in the right
circumstances they can be very powerful tools. Used incorrectly, the results
can be extremely detrimental.

Companies
usually award RSS to very early employees or to executives or directors in
established public companies. A key reason for using this tool at private companies
is their exemption from IRC 409A, the deferred tax rules. Private companies are
not required to determine a value for the company stock under IRC 409A when
using RSS. Key reasons for public companies to use RSS include helping
executives meet share ownership guidelines and providing a tool that delivers shareholder
dividends. RSS use has a mixed reputation. Shareholders like the fact that RSS
are less leveraged than stock options, but they hate the fact that value is
built in. Since they cost nothing to the participant, RSS awards have some
value even if stock prices go down.

It
should be noted that over the past 15 years many companies have moved from RSS
to another type of FVA, Restricted Stock Units (RSUs), which will be covered in
my March 7, 2013 post. FVAs are excellent retention tools. They provide a safe
and steady component to an equity compensation package that may otherwise seem
capricious and volatile. While RSS are a tool that does not work for every
occasion, they are something that early-stage start-ups and successful public
companies should have at their call. These instruments have limited uses, but
when they are great, they are better than anything else.

Note:
RSS awards allow far more flexibility than be discussed in article of this
length. This is part of a series of posts on equity compensation instruments
that will run the first Thursday of every month for the foreseeable
future.  Please reach out to me directly
if you have any questions or can’t wait for future postings on a specific topic.

Dan Walter is the President and CEO of Performensation an
independent compensation consultant focused on the needs of small and mid-sized
public and private companies. Dan’s unique perspective and expertise includes
equity compensation, executive compensation, performance-based pay and talent
management issues. Dan is a co-author of “The Decision Makers Guide to Equity Compensation”, “If I’d Only Know That”, “GEOnomics 2011” and “Equity Alternatives.”
Dan is on the board of the National Center for Employee Ownership, a partner in the ShareComp virtual conferences and the founder of Equity Compensation Experts, a free networking group. Dan is frequently requested as a
dynamic and humorous speaker covering compensation and motivation topics.
Connect with him on LinkedIn or follow
him on Twitter at @Performensation and @SayOnPay