Restricted Stock and Direct Stock Purchase PlansRestricted 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 StockRestricted 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
- Awards provide service or performance targets for employees to achieve before actually receiving shares or having the right to acquire shares.
- Shares can carry dividend or voting rights, if the company chooses.
- Unlike stock options or stock appreciation rights, restricted stock retains some value for employees even if the price goes down.
- Capital gains treatment is available on all or part of the gain on the shares, provided a "Section 83(b) election" is made.
- Unlike stock options or stock appreciation rights, restricted stock provides some value even if the share price declines.
- Restricted stock requires fewer shares to provide a similar level of benefit as compared to what would be needed for options (because awards have value even if the share price declines).
Restricted Stock Disadvantages
- The restrictions may make ownership seem like an unlikely benefit. If an employee purchases shares, especially at the market price, but then cannot actually take possession of them until certain events occur, buying the shares may not seem very attractive.
- Restricted stock has no value unless there is a market for the shares at some point. Employees must believe this is a real possibility, not just a corporate intention.
- The company cannot take a tax deduction for the value of the gain employees eventually realize if employees have made a Section 83(b) election to have the gain taxed as a capital gain.
- If the stock is performance vested, it is subject to variable accounting rules requiring changes in the value of the award be charged as a compensation expense.
- Relative to other plans, restricted stock is a more complicated approach and can involve significant financial risks for employees if they choose to make a Section 83(b) election in order to receive capital gains treatment on any increase in share value they eventually realize.
Direct Stock Purchase PlansThese 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 AdvantagesLike restricted stock, direct stock purchase plans also have their pros and cons. Among the arguments for these plans are the following:
- If employees own shares as individuals, as opposed to through some kind of trust or similar arrangement, they may feel more like real owners.
- If employees have to buy shares, they are making more of a real commitment to the company.
- The purchase of shares infuses new capital into the company.
- Ownership is only held by people interested enough to make a financial sacrifice.
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.
- If employees have to buy shares, how many will be able to do so? Will ownership end up being distributed mostly to higher paid people? While this may be the company's objective, it will mean the company will be unlikely to be able to develop an ownership culture in which most or all employees will think and act like owners. Some owners think just making stock available to people is enough to accomplish this purpose, even if they do not buy it, but there is little reason to believe this is the case.
- If a company asks employees to buy shares, will they feel pressured to purchase them even when they are not in a financial position to take that risk? Will they resent what they may perceive as subtle—or not so subtle—pressure? Will they rush to sell shares at the first opportunity to minimize their financial risk?
- Will employees who own shares directly be able to sell them when the like, thus reducing the incidence of employee ownership in a company? If they cannot sell when they like, will this make them less interested in owning shares?
- If there are stock registration or other legal forms and procedures to comply with, will the costs of compliance justify the amount of investment employees make?
- Direct stock purchases must be made with after-tax employee dollars; other plans can arrange for more favorable terms.