Ask the Wizard

I get so many search referrals to this blog with queries like "restricted stock vs. options", probably because i wrote a post titled "restricted stock vs. options", it's time to finally write about "restricted stock vs. options". This is a simple yet complicated topic, and I will undoubtedly leave out a bunch of stuff and get ten things wrong, but other than that, I hope this will prove helpful and enlightening. Please refer to Volume II of "Ask Dr. Phil, The Startup Years" for anything I might be leaving out here.

You can look up most of the basics like "what is restricted stock" or "what is an option" or "who shot JR" on the Google. I won't define terms here, I'll just talk about some pros and cons of when you might use restricted stock instead of options or vice versa and why. Big tip of the hat to Brad Feld and David Hornik who filled in a bunch of blanks for me on this.

When would you issue restricted stock instead of options? In a startup, one time that you might do this is very early on for a few executives or very early 'founder-ish' hires. The reason you might issue restricted stock instead of options generally has to do with tax treatment. The general deal with options is this - you get an option to buy stock at some price. The day you exercise that option is the day you start holding the stock. If you sell the stock before you have held it for a year, you pay income tax on the gain, even if you held the option itself for 4 years (and if you sell after you've held the stock itself for a year, you pay long-term capital gains). You can imagine lots and lots of cases in which the only time an employee would exercise their options is when they are about to turn right around and sell the stock, so in these cases, the employees are looking at income tax. Enter restricted stock. Maybe. Probably not though.

Restricted stock, on the other hand, is also really a stock grant that promises vested stock to the holder, but can work like so.....you're granted the stock, but it is restricted in that the company has a right to buy it back on the cheap according to a vesting schedule. So, the good news in this case is if you file a special 83b election with the tax man (more on this below), then the date the long term capital gains clock starts ticking is the date you buy the restricted stock (even though it is at risk over the course of the vesting schedule). So, good news is better clock ticking on long-term capital gains treatment and bad news is that you actually have to purchase the stock or pay tax now on a grant of stock that's priced below fair market value. So unlike options, you've got cash out of pocket on equity that's not going to be liquid, in all likelihood, for quite some time. One reason you might consider this approach more right at startup time is that the common stock hasn't yet acquired much/any value, so the purchase price or income tax can be next to nothin. You don't wanna have to buy $100k worth of restricted stock in shmucky.com only to watch shmucky.com go out of business 18 months later when the market for pre-washed online shmucks dries up or you quit, etc.

Is that all? No, that's not all. If that were all, the tax code and business would be simple, and you might see a lot more people getting restricted stock at startup time than options, and the chances of the tax code and company reporting requirements and so forth being simple are unlikely.

A non-tax restricted stock vs. options consideration for entrepreneurs and startups is that there are lots of issues involved with having too many stockholders. These range from things like inability to run as a pass-through entity like an S-corp if there are too many stockholders to things like requirements of x% of the stockholders on approval of mergers to all sorts of other reporting requirements that make it unattractive to have so many actual stockholders as opposed to options holders.

Then there's the tax kicker regarding why more companies don't just offer restricted stock grants instead of options to more people. This is the stay tuned for more bad news part that I mentioned earlier. Let's say the fair market value of the common stock is now $3 and you grant some employee 10k shares at zero cost to the employee with a four year vesting schedule. In order that the clock start ticking at grant time on the long term capital gains treatment, the employee files a special 83b election with the IRS. This election essentially says "i want to establish cost basis in the stock now and a gain (or loss) will be recognized only when i sell". As part of this, you then have to pay income tax on the difference between the grant and the fair market value now, at the time of grant. Six months later the employee quits or the company goes bankrupt and in either case the employee has no vested shares. Does the employee get to now claim a loss? What do you think the answer is going to be? You are right, the answer is no way, the employee is out the tax bill plus whatever they paid for the restricted shares.

So, ok, what if you don't file special election 83b? In that case, you pay no tax at grant time but only when the grant vests (more accurately, as each chunk vests). HOWEVER, at that time, you now owe income tax on the difference between what you paid for the stock and the fair market value at the time the stock vested. If the stock has appreciated, you now wish you'd been granted options. Very bad. Not good. Bummer. Since the potential tax liability on such stock could be massive if it really appreciates, anybody in their right mind files an 83b election, since that's kind of the whole point.

Having said all this, when do restricted stock grants make the most sense for a startup? Again, they make the most sense in the early going, before the common has any real value at all, and even then only for a handfull of executives so that there aren't too many stockholders. The too many stockholders issues have little to do with transparency and everything to do with all the extra burdens heaped on companies with certain numbers of shareholders....burdens that startups don't need while they're trying to run fast and grow over the first several years.

Thus, you see some savvy executives who might come into a company in the very early days that understand the benefits of asking for restricted stock instead of options, and in those cases restricted stock can be a better deal for the executive and can make sense and this is not a ridiculous request. As you grow and finance the company and add more employees, however, options plans are more appropriate as they don't force employees to come out of pocket now with cash they might not be able to recoup later.

NB: I'm not referring in here to "Restricted Stock Units", which are another subject altogether. When you hear that companies like Microsoft have stopped granting options and started granting restricted stock, what they are really talking about is something called restricted stock units, which are a promise to grant unrestricted shares according to a vesting schedule, and you don't need to worry your pretty little head over those right now.

Clear as mud? Good. The Wizard is all about sleight of hand and misdirection. <Poof>