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

Stickman - Equity Compensation - RSS
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.

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

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