Startups often use equity to help attract and keep talented workers. This article outlines the differences and similarities of stock options and restricted stock purchase agreements, and why most early-stage startups that issue stock shortly after formation select restricted stock when compensating their workers.
First, a few clarifications:
What are stock options?
Stock options give employees the right to buy a specific number of shares of the company at a specified price (known as the “strike price”) during a window of time.
What is restricted stock?
Restricted stock vests over time, typically over a four-year period. If the worker leaves the company before all of the stock has vested, the company has the right to repurchase the unvested stock back from the worker.
How are stock options and restricted stock similar?
Both stock options and restricted stock encourage loyalty to the company by incentivizing the worker to remain with the employer for a minimum period of time.
In addition, both provide an important tool to startups that may not have much cash to attract top talent.
Finally, both encourage the worker to increase the value of the company, which creates a unity of interest between the worker and the employer.
How are stock options and restricted stock different?
One key difference is restricted stock vests over time regardless of whether the value of the stock increases. In contrast, stock options do not automatically vest. Instead, stock options have an expiration date and the worker can only exercise their options during a specific window of time.
What are the benefits to stock options?
With stock options the worker is not out any money if the stock price does not rise because they can decide not to exercise the stock options.
That being said, for new startups the fair market value for restricted stock is often only the par value of the shares and so the purchase price is typically very minimal.
Why are restricted stock agreements often better than stock option plans for most early-stage startups?
Each situation is unique, but most early-stage startups use restricted stock rather than stock options for five reasons:
1. No need for a 409(a) valuation.
The board of directors is required to determine the fair market value of stock for both restricted stock and stock options.
The key difference for restricted stock is the fair market value of the stock when it is purchased, which for very early-stage startups is often the par value of the stock, as the company shortly after formation does not yet have much value.
In contrast, under IRS Regulation 409(a), if the the valuation of stock options is done by a professional valuation company, the valuation is presumed to be correct and the burden is on the IRS to prove otherwise if there is ever an audit.
However, if the company does not use a professional valuation firm, if there is ever an audit, the company — and not the IRS — has the burden of proving the valuation is correct. As a result, companies typically hire an outside valuation firm to do the valuation of stock options. The thousands of dollars it costs to have 409(a) valuations completed, could instead be spent on other things for the company, such as software programming or marketing.
After a company has gained value, the valuation of grants of restricted stock is no longer par value, but for an early-stage start it is much easier, and less expensive, to properly determine the value of restricted stock than it is stock options.
2. Stock options could become worthless.
Also, a stock option could become worthless. For example, a stock option grant with a strike price of $10 has no value if the fair market value of the stock is later determined to be $8. In contrast, if restricted stock is granted when the stock is trading at $10 and is later worth $8, the stock is still worth $8 and has only lost 20% of its value.
3. Restricted stock might better motivate workers.
In addition, some workers might be better motivated with restricted stock than with stock options, because workers will get shares of the stock regardless of whether its value increases. In contrast, stock options are worthless if the value of the stock goes down or if the worker fails to exercise the stock option.
Restricted stock, therefore, might better motivate some workers to think and act like owners of the company, take a personal interest in the company and be more focused on meeting the company’s objectives — because they will obtain shares regardless of whether the stock price goes up or down.
Stock options might do less to instill a sense of ownership, because the worker could invest years in the company only to find that the value of the stock has decreased, leaving no value in the stock options. Because the value of the stock may not increase, the worker might not have the same amount of loyalty to the company than if they had been granted restricted stock.
4. Immediately starts the clock for the lower capital gains rate.
If the worker makes an 83(b) election, the income from the restricted stock grant will be recognized at the time of the stock “transfer” (its purchase date), rather than when the stock vests. The reason this is important is if an 83(b) election is made, the long term capital gains holding period also begins on the purchase date of the restricted stock rather than when the stock vests.
5. Workers may be more likely to focus on the long-term value of the company.
Finally, a worker with stock options might be more likely motivated to increase the short term stock price so they can exercise their stock options, even if this comes at the detriment to the longer term growth of the company.
For all of these reasons, most early-stage startups that issue stock shortly after formation, use restricted stock instead of stock options as they often provide a superior method of compensating and motivating workers.
Disclaimer: This article discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Doug Bend and Ronak Patel expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this article.
This article originally appeared on the author’s website.