Restricted Stock Option: How It Differs from Traditional Stock Options‍

Casey Fenton

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November 7, 2023

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In the highly competitive tech industry, attracting top talent is the name of the game, and equity has become the golden ticket. But did you know the game itself is changing? More and more tech companies are shifting away from traditional stock options, opting for alternatives that offer both employees and employers unique advantages. Enter restricted stock options—a derivative of the old and out-of-touch stock options. It has since revolutionized equity compensation not just within Silicon Valley, but across many industries and startup ecosystems.

So read on and find out why restricted stock options are gaining traction and how they stack up against traditional stock options in terms of taxation, voting rights, and strategic implications for your company.

Why a Restricted Stock Option is "Restricted"

When you hear the term "Restricted Stock Option," it's important to understand that the 'restricted' label isn't a mere formality. These options are subject to specific limitations or conditions that make them different from their traditional counterparts. So what are these restrictions, and why do they matter?

1. Time-Based Restrictions

The most common type of restriction is time-based. Typically, these shares are subject to a vesting schedule, meaning you earn them over time. The restrictions usually lift after you've been with the company for a predetermined period, often ranging from one to four years. During this period, if you leave the company or are terminated, the unvested shares typically revert back to the company.

2. Performance-Based Restrictions

Another form of restriction is performance-based. Here, the vested shares are tied to specific milestones that could be individual, departmental, or company-wide. These might include achieving a certain revenue target, launching a product, or hitting other key performance indicators or KPIs. Until these conditions are met, the stock remains restricted.

3. Exit Event

Certain companies tie the lifting of restrictions to an exit event, such as an Initial Public Offering (IPO) or a company acquisition. In these cases, the stock remains restricted until the company goes public or is purchased by another entity. This aligns the interests of the employee with the long-term success of the company, as they can only cash out when everyone else does.

4. Forfeiture Rules

In most cases, if you leave the company before meeting the restriction criteria, you'll have to forfeit your restricted stock options. This provision incentivizes employees to stay with the company through critical periods and milestones, benefiting both parties.

5. Legal and Regulatory Restrictions

Finally, some restrictions come from legal or regulatory requirements. For instance, shares might be restricted due to Securities and Exchange Commission (SEC) rules or other governmental regulations. Failure to comply can lead to severe legal consequences, making it vital for both employers and employees to understand these restrictions fully.

Why Do Restrictions Matter?

Understanding the restrictions is vital for both you as a company owner and your potential equity-holding employees. The type of restriction impacts not just when and how the stock can be sold but also has significant tax implications. Furthermore, restrictions can serve as both an incentive and a limitation, making it a strategic choice for your company's overall compensation package.

How Different is Restricted Stock Option from Traditional Stock Options?

At first glance, restricted stock options and traditional stock options may appear quite similar—both are forms of equity that companies can offer to employees as part of their compensation packages. However, there are critical differences that can substantially impact both the employee and the company:

Vesting Period vs. Continued Restrictions

While both restricted stock options and traditional stock options usually come with a vesting period—meaning you earn the right to them over time—the similarities often end there. Once traditional stock options are vested, you are generally free to exercise them at will, assuming you meet any company-set exercise windows.

In contrast, restricted stock options continue to carry conditions even after vesting. Whether it's a specific time period you must remain with the company or certain performance metrics that must be met, these restrictions can prolong the time before the stock truly "belongs" to you.

Tax Implications

One of the most significant differences between the two lies in how they're taxed. Traditional stock options are usually not taxed upon grant or vesting, but rather upon exercise, allowing for potential tax advantages if the stock appreciates in value. Restricted stock options, however, are often taxed upon vesting, unless an 83(b) election is filed, which changes the timing of the tax event to the grant date.

Risk and Reward Profile

When considering risk and reward, restricted stock options are generally less risky than traditional stock options. If the company's stock price falls, traditional stock options can become worthless, as they grant the right but not the obligation to purchase shares at a predetermined price. On the other hand, restricted stock options, even if the stock price drops, hold intrinsic value simply for being shares of the stock.

Dividends and Voting Rights

This is an area where restricted stock options have a notable advantage. They often confer dividends and voting rights to the holder from the date of grant, unlike traditional stock options, which do not offer such rights until the option is exercised and the stock is actually owned.

Administrative Complexity

From a company's perspective, restricted stock options can be simpler to administer. They avoid some of the complexities involved with traditional stock options, like setting an exercise price or dealing with underwater options. However, the restrictions can sometimes require more rigorous tracking to ensure compliance with vesting or performance conditions.

How is a Restricted Stock Option Taxed?

Tax treatment is one of the most intricate aspects of any equity compensation plan. restricted stock options are no exception. Unlike traditional stock options, where taxation is generally straightforward and occurs at the exercise of the option, the tax implications for restricted stock options can be more nuanced. Here's what you need to know:

1. Taxation at Vesting

The most straightforward case of taxation for restricted stock options is at the point of vesting. When the stock vests and the restrictions lift, the value of the shares is considered income and taxed at your ordinary income tax rate. This income is subject to federal, state, and local taxes, as well as Social Security and Medicare taxes.

2. The 83(b) Election

However, you can opt for a different taxation route through what's known as an 83(b) election. An 83(b) election allows you to pay all your taxes upfront, based on the stock's value at the grant date instead of the vesting date. This can be advantageous if you expect the company's stock value to appreciate significantly. Do note, however, that this election is irrevocable and comes with its own set of risks—mainly if you forfeit the stock or it decreases in value, you don't get a tax refund.

3. Taxation at Sale

Once the restrictions on the stock lift and it's sold, any difference between the sale price and the value of the stock at vesting (or the grant date, if you made an 83(b) election) is considered a capital gain or loss. The tax rate for this will depend on how long you've held the stock: a short-term capital gain if held for less than a year and a long-term capital gain if held for more than a year.

4. Company Tax Deductions

From the employer's standpoint, the tax situation is somewhat simpler. The company generally receives a tax deduction equal to the amount recognized as income by the employee, either at the time of vesting or at the time of an 83(b) election. This helps offset some of the costs associated with offering restricted stock options as a form of compensation.

5. Advanced Tax Planning Strategies

Given the complexity and potential financial impact of these tax rules, many people opt for advanced tax planning strategies. These could involve timing the exercise and sale of options to minimize tax liability or perhaps holding onto the stock long enough to qualify for lower long-term capital gains tax rates.

Deciding Between Restricted Stock Option and Traditional Stock Option for Your Company

Choosing the right type of equity to offer is a balancing act, and the choice could significantly impact your ability to attract talent, your company’s tax situation, and even its governance.

1. Consider Your Employees

Young startups might opt for traditional stock options, which are less taxing upfront and might offer higher rewards. More mature companies or those looking to mitigate risk might find restricted stock options more appealing.

2. Consider Your Company's Stage

For early-stage startups, traditional stock options can be more attractive because they're less of a tax burden for employees. Established companies might find the predictable nature of restricted stock options more fitting.

3. Consider Governance

If you want to keep voting rights closely held, traditional stock options may be the better fit.

The complexities involved in equity compensation mean that professional advice is often needed. Consult tax professionals, legal advisors, and financial experts to make an informed choice.

Make Your Choice Wisely

Equity compensation is far from a one-size-fits-all solution. The choice between restricted stock options and traditional stock options involves multiple layers of decision-making, from taxation to company governance. Carefully assess the distinctions of each to make the choice that best suits your company’s unique needs.

In case we’ve made a point about the good stuff restricted stock options can do for you and your employees, don’t hesitate to book a demo with Upstock today and we’ll show you how equity compensation management can be flexible and cost-efficient.

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ABOUT THE AUTHOR

Casey Fenton

Founder, Upstock & Couchsurfing, AI and Equity Innovator

Casey Fenton, the founder of Upstock & Couchsurfing and an AI and equity innovator, has revolutionized how we perceive and implement equity in the workplace. His foresight in creating platforms that not only connect people but also align their interests towards communal and corporate prosperity has established him as a pivotal figure in technology and community building. Casey speaks worldwide on topics including ownership mindset, worker equity, With Upstock and Couchsurfing, he has demonstrated an unparalleled expertise in harnessing technology for the betterment of community interaction and organizational benefits.

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