Part 2 – Restricted Stock

The “Great Resignation” of 2021 and the low unemployment rates in the first half of 2022 have caused businesses to increase their focus on employee retention. What options do companies have to attract and retain employees in such a difficult labor market?

As discussed in Part 1, sharing equity with employees is not a new phenomenon, but it is becoming more common and has come to be expected by top talent. There are many reasons businesses choose to share equity with their employees: to reward employees for prior contributions or outstanding performance, to create a sense of ownership, foster an entrepreneurial culture and mindset, and to drive attainment of long-term goals and metrics. In the context of the Great Resignation, equity sharing is also a way for a business to differentiate itself to attract and retain the most talented employees. Equity sharing plans take many forms, including sharing of actual equity of the company through stock purchases and grants, stock options, ESOPs, and profits interests, as well as equity-mimicking arrangements like phantom stock, stock appreciation rights, and change of control bonuses.

This article is Part 2 in a series of articles that will delve into the different types of equity-sharing arrangements that businesses can deploy. Regardless of the form of equity-sharing arrangement, the key to a company getting the maximum benefit out of a plan is to consistently communicate to employees the value of the plan, provide participants with information about the business, and consult participants so that they feel included in the company’s decision-making process. For simplicity, I use corporate terminology throughout this article (e.g., “stock” rather than “membership interests” as in an LLC), but the concepts are mostly the same.

One way businesses can share equity with employees is to permit employees to purchase the company’s stock (often company-financed and paid out of bonuses). The company usually sells its shares directly, but current shareholders may be permitted to sell some of their shares depending on the circumstances. However, offering employees the opportunity to purchase shares of a company’s stock at fair market value is not that attractive to most employees because the employee is paying to acquire what are usually illiquid securities.

A more popular option is for the company to make stock grants to employees as additional compensation. However, stock grants are taxable to the employee as ordinary income. An employee receiving a stock grant must pay ordinary income tax on the difference between the price paid for the stock, if any, and its fair market value on the grant date. Because of their drawbacks, stock purchases and grants are usually only used in the earliest stages of a business when the equity in the business has little to no value. Still, stock purchases and grants can be excellent tools for the founding team and early employees because the employees immediately become co-owners of the business, making them more invested in its success. Additionally, stock ownership usually conveys some voting rights, giving the employee a say in the management and direction of the business and further cementing their loyalty and sense of ownership. The icing on the cake for recipients of stock grants is that, for purposes of qualifying for capital gains tax rates and qualified small business stock, the holding period begins on the grant date. As a result, if there is a liquidity event (e.g., sale of the company), any income recognized from ownership of the shares could qualify for lower tax rates.

As with options, stock grants and even some stock purchases (particularly those made for nominal value by the founding team and early employees) are often subject to vesting. Vesting is usually time-based (e.g., 12/48 (25%) of the shares vest after one year of continuous service to the company, with 1/48 of the shares vesting each month thereafter). Vesting can also be based on the attainment of specific metrics by either the employee or the company (e.g., for a chief revenue officer, 250,000 shares vest upon the company exceeding $1 million in annual revenue). Acceleration of vesting upon a change of control (e.g., sale of the company) is customary.

Stock granted subject to a vesting schedule is often referred to as “restricted stock.” Although the employee owns the shares as of the grant date if the employee leaves before their shares vest, their unvested shares are forfeited. This is an example of what Section 83 of the Internal Revenue Code (the “Code”) refers to as a “substantial risk of forfeiture.” When a substantial risk of forfeiture exists, as with a grant of restricted stock, the employee is not required to recognize income at the time of the grant. Instead, the employee is only required to recognize income on the date that the substantial risk of forfeiture lapses. For restricted stock, the date that the substantial risk of forfeiture lapses is the date the shares vest. However, under Section 83(b) of the Code, recipients of restricted stock can elect to recognize income on the date of the transfer rather than wait until the restrictions lapse. This is accomplished by the employee filing a Section 83(b) election with the U.S. Internal Revenue Service, postmarked within 30 days of the grant.

Why would a recipient of restricted stock elect to take into income the value of the restricted stock on the date of the grant if they are not required to do so? A recipient of restricted stock might want to make a Section 83(b) election if they expect the value of the shares to increase during the vesting period. If a recipient of restricted stock is confident that their shares will vest (i.e., they will remain employed by the company during the vesting period) and that the shares will be more valuable when they vest, then a Section 83(b) election could substantially reduce the amount of income tax owed on the restricted stock grant.

For example, if an employee receives a grant of 100 shares of restricted stock valued at $100 and when those shares vest their value has increased to $250, the employee would owe income tax on $250. If that same employee made a timely Section 83(b) election, they would take into income the value of the shares on the grant date (rather than the vesting date), which is only $100 (rather than $250). On the other hand, if the company fails and the shares become worthless, the employee who made the Section 83(b) election will have already paid income on tax on the now worthless shares. A Section 83(b) election is irrevocable and, as illustrated in the above example, can be a gamble for the employee. To realize the benefit of the Section 83(b) election, the employee must remain employed until the restricted stock vests, and the value of the restricted stock must increase over the vesting period. As a result, employees receiving restricted stock grants should be encouraged to consult their tax adviser to determine whether making a Section 83(b) election is in their best interest.

Stock grants must be approved by the Board of Directors of the company and are usually granted pursuant to a stock plan and restricted stock grant agreement setting forth the terms of the restricted stock grant, including the vesting schedule, and the general rules that govern all shares of restricted stock granted under the plan. The restricted stock grant agreement should include a right to recoup unvested shares upon termination of employment, a right of first refusal in favor of the company (allowing the company the right to match any third-party offer to acquire the shares), and a right to repurchase the shares at the then fair market value in the event of an involuntary transfer (e.g., death or divorce of the stockholder).

For a company to obtain the maximum benefit from an equity sharing arrangement, via a stock plan or otherwise, the emotional aspects of the plan are as important as the financial aspects. The benefits of the plan should be thoroughly and regularly communicated to employees and prospects, and the company should take care to ensure that participants feel like they are truly co-owners of the business. The primary purpose of equity sharing is to fundamentally change how employees feel about the company they work for. Ideally, this will result in a financial benefit to the company manifested through higher productivity, improved morale, greater retention, and higher-quality applicants.

Go back and read Part 1 of How to Attract and Retain Employees During the Great Resignation.

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