Restricted Stock or Stock Options - Which One is Right for my Company?

Private companies utilize equity compensation to attract and retain talent and plan future use of company capital.  In preparing a compensation plan, many startups debate between two types of equity compensation awards – restricted stock or stock options.  Highlighting the difference between restricted stock and stock options is beneficial when creating an effective compensation plan that aligns best with the goals of the company and the needs of its service providers.  These awards give service providers a meaningful stake in the company’s success by offering the opportunity to own stock, which usually means gaining both economic and voting rights in the company.  Two important considerations in deciding which award to issue are the company’s value and the tax implications of both awards.  Broadly speaking, when a company issues stock, the value of the stock is taxable.  So, the ability for someone to pay taxes on such value could be an unwelcome burden.

Restricted Stock

Restricted stock is a direct grant of actual ownership of the stock that vests upon grant. The stock can be “restricted” due to several reasons.  For instance, the stock must comply with transfer restrictions required for private companies, such as the inability to sell in the public markets.  In addition, the company can place various conditions on the stock, such as a vesting schedule or employee performance.   Commonly, the company would also reserve the right to repurchase the stock that would lapse after all vesting periods. 

A service provider receiving restricted stock will pay taxes when the stock vests and then again when he or she sells the stock.  During the early stages of a company, restricted stock generally has little value.  Since restricted stock is taxed upon vesting, the resulting tax could be minimal.  However, as the company grows in value, the tax owed could be significant, and the recipient may be unable or unwilling to pay taxes on the value of the stock.

Recipients of restricted stock may ease some of the tax burden by paying the tax before a stock vest via an 83(b) election.  An 83(b) election is an election made with the Internal Revenue Service whereby the recipient of equity (for example, restricted stock) elects to be taxed on that equity on the date of the grant rather than on the date the equity vests. While the recipient cannot get back the amount he or she paid in taxes as of the date of the grant of the restricted stock, the possibility of a reduced tax payment could be a welcome exchange.  To pursue an 83(b) election, the recipient must do so within 30 days of the grant of the stock.  Failing to make the election in time will result in the loss of the 83(b) election forever (the IRS is very strict when it comes to this deadline, and will only allow exceptions under very limited circumstances), and the recipient will have to pay for the difference between the value at the time of vesting minus the value at time of grant, which could result in a very high tax bill.    

Stock Options

When the value of the stock reaches the point where a service provider would be hesitant to use their own money to pay the tax due at vesting, issuing stock options may be a more feasible and attractive option.  Stock options give service providers a right to purchase stock at a specified price, also known as the strike or exercise price. If and when the service provider choses to exercise his or her options, he or she may purchase some or all of the stock allotted at the strike price.  The strike price is set in a stock option agreement and is usually set at the Fair Market Value (FMV) of the company at the time of grant (more on this in the 409A valuation discussion below). To illustrate how options generally work, let’s say ACME Co. hires Maria as an employee and offers her an option to purchase 100,000 shares at the current FMV of the company, which is $.10 per share. This $.10 price would be the strike price. Fast forward 5 years, and each ACME Co. share is now worth $1. Assuming Maria has met all vesting provisions tied to the stock option (if any), if Maria were to exercise all of the options at that point in time, she would pay $10,000 to exercise the options. In return, Maria would receive 100,000 shares of ACME Co. valued at $100,000.

Companies can issue two different types of stock options: incentive stock option (ISO) or non-qualifying stock option (NSO).  Although the specific differences and advantages of ISOs and NSOs are beyond the scope of this article, it is important to highlight the basic differences between the two. ISOs can only be granted to employees and NSOs can be granted to any service providers, including employees, independent contractors, and directors. Whichever kind of stock option a company chooses to award, important tax considerations arise once an option is exercised.

In the case of an NSO, the service provider would have to pay taxes when the he or she exercises the options. That service provider would be taxed on the difference between the share price at the time option holder exercises the option and the strike price at ordinary income tax rates. So, in the example above, if Maria were granted NSOs, she would have to pay taxes on the $90,000 at the time she exercises her NSOs (that is, the difference between $100,000 – the value of the shares at the time of exercise – and $10,000 – the value of the shares at the strike price).

ISOs, on the other hand, are generally more advantageous for employees because employees do not incur a tax bill when they exercise their options. Instead, employees will pay taxes if and when they eventually sell their shares. If the employee holds the stock that it obtained after exercising the options for more than one year, the employee will pay long-term capital gains tax on the difference between the exercise price and the price the employee eventually sells the shares for. If the employee holds the stock for less than one year, the employee would pay ordinary income tax rates on the difference between the exercise price and the price the employee eventually sells the shares for. Keep in mind that, in addition to the service provider being an employee, there are other requirements that must be met in order to validly issue ISOs.

Another important piece of granting stock options is that startups generally have to seek independent valuations (referred to as 409A valuations). A 409A valuation is essentially an appraisal of the company’s stock, and will determine the strike price, which the IRS requires it be at or above the FMV of the shares of the company. Private companies need to conduct independent valuations because, unlike public companies where the price per share is generally known, share prices are not readily available. Although in-depth look at 409A valuations is beyond the scope of this article, it is worth mentioning here that failing to conduct a 409A valuation when issuing stock options can result in highly detrimental tax consequences to both the service providers receiving the stock options and the company itself.

Lastly, it is important to note that stock options often give the option holder more flexibility.  The option holder can control the risk that comes with owning stock in a private company by choosing to hold on to the option and wait for a better time to exercise (subject to the vesting schedule), or not exercise the options at all.

Deciding Between the Two

Choosing between restricted stock or stock options weighs a lot of factors.  When considering the tax implications, it is important for companies to weigh how much people are willing to pay for the value of the stock.  For early stage startups, restricted stock may be an appealing option if the value of the stock is low, resulting in a smaller tax burden for the recipients.  As the company begins to grow in value, stock options may be the more practical route.  However, stock options may present the added cost of completing a 409A valuation for companies (the costs associated with completing a 409A valuation can vary depending on the size of the company). Still, restricted stock and stock options are two of the most common ways in incentivizing people to join and remain at a private company. It is important to remember that board approval is needed for either option before finalizing the equity compensation plan.  Ultimately, companies should structure equity compensation plans to maximize tax treatment allow those they seek to incentivize to purchase equity with little money coming out of their own pockets.

DISCLAIMER: The information in this article is provided for informational purposes only and should not be construed or relied upon as legal advice. This article may constitute attorney advertising under applicable state laws.