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Restricted Stock and Direct Stock Purchase Plans

Restricted stock and direct stock purchase plans have become increasingly popular as ways to compensate employees. Often used just for key employees, they also can be used more broadly.

Restricted Stock

Restricted stock refers to shares whose sale or acquisition is subject to restrictions. In employee ownership plans, this typically would mean that an employee would be given shares or the right to buy shares (perhaps at a discount), but could not take possession of them until some time later when certain requirements have been met (or, to put it differently, restrictions have been lifted), such as working for a certain number of years or until specified corporate or individual performance goals have been met. If the employee does not meet the requirements for restrictions to lapse, the shares are forfeited. Some plans allow the restrictions to lapse gradually (for instance, an employee could buy 30% of the stock when the shares are 30% vested); others provide the restrictions lapse all at once. Employees can choose whether to be taxed when the restrictions lapse, in which case they will then pay ordinary income tax on the difference between the current price and anything they may have paid for the shares, or they can pay when the right is first granted by filing an 83(b) election. In that case, they pay tax on the difference (if any) between the current price and the purchase price at ordinary income tax rates, then pay capital gains tax when they actually sell the shares. While the employees holds the restricted stock, it may or may not provide dividends or voting rights. Dividends and voting right rules are generally a matter governed by state law requirements. If state law allows it, company articles of incorporation can provide that voting rights and/or dividends on shares that would otherwise grant these rights are not granted on unvested shares. It may also be possible for an employee to be granted a restricted stock award on stock that does not pay dividends or grant voting rights to anyone.

One of the great advantages of these plans is their flexibility. But that flexibility is also their greatest challenge. Because they can be designed in so many ways, many decisions need to be made about such issues as who gets how much, vesting rules, liquidity concerns, restrictions on selling shares, eligibility, rights to interim distributions of earnings, and rights to participate in corporate governance (if any).

Restricted Stock Advantages

Restricted Stock Disadvantages

Direct Stock Purchase Plans

These are plans in which employees can purchase shares with their own funds, either at market price or a discount. In some cases, employers will provide below-market or non-recourse loans to help employees purchase the shares. Employees then hold the shares as individuals with the same rights as other holders of the same class of securities. (We are not referring here to tax-qualified employee stock purchase plans, through which employees usually buy shares through payroll deductions.)

Direct Stock Purchase Plan Advantages

Like restricted stock, direct stock purchase plans also have their pros and cons. Among the arguments for these plans are the following:

Direct Stock Purchase Plan Disadvantages

Our book Equity Alternatives: Restricted Stock, Performance Awards, Phantom Stock, SARs, and More includes detailed chapters and model plan documents for restricted stock and direct stock purchase plans. Also see GPS: Restricted Stock and Restricted Stock Units.

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