The new business idea is coming together, the circle of friends and advisors is tightening and it’s time to pull the proverbial trigger on this thing. The questions arise, “who’s in?” “who’s out?” and “how do we set this up?” During the initial startup phase, it is important to keep key players involved, and maintain the flexibility to let them go if things aren’t working out. Most startups don’t have the cash to pay salaries high enough to keep people involved, so a mix of compensation options is often on the table. A common solution is restricted stock (or restricted units in the LLC context), which is equity that is subject to certain contractual restrictions on its ownership, typically including:
- Restrictions on transfer or resale;
- The company’s right to repurchase the stock for a certain period of time after the employee’s termination of employment. These restrictions remain in place until the restricted stock vests, based on the employee’s continuous employment. A vesting period typically used by a startup company is four or five years with a one-year cliff, followed by ratable monthly vesting. For example, restricted stock that vests over a four-year period with a one-year cliff vests as follows: a quarter of the restricted stock vests one year after the grant date, and 1/48th of the restricted stock vests each month thereafter. If the employee’s employment terminates before the end of the vesting period, the company may exercise its repurchase right within a certain period of time following the employee’s termination of employment (typically 90 days);
- The repurchase price for unvested shares is typically the original cost of the equity or, in some instances (such as a termination for cause), the lower of the original cost of the equity or the fair market value of the shares on the date of termination;
- In certain circumstances, vested shares can also be subject to repurchase and the repurchase price can vary depending on the circumstances surrounding the employee’s termination of employment. If the employee is terminated for cause, the repurchase price is typically the lower of the original cost of the equity or the fair market value of the shares on the date of termination. Where vested shares are subject to repurchase in case of a resignation or termination without cause, the repurchase price would typically be the fair market value of the shares.
Restricted stock is most commonly awarded to a startup company’s founders or during the initial startup phase of a company. Founders and other initial employees of the company typically buy restricted stock for a nominal cost, because the value of the shares is exceedingly low when the company is just being formed. At a later stage, the common stock value is typically higher and, even if still low per share, an employee may not be able to afford to purchase the shares for their fair market value.
In a corporation, the terms of the restricted stock would be covered in the company’s governing documents and/or a shareholders agreement between the founding and early shareholders receiving the restricted stock. In a limited liability company, the terms of the restricted units would be contained in the company’s operating agreement.
Unless the employee files a Section 83(b) election (described below), the employee is not taxed on the grant date. However, in the year the restricted stock vests, the employee must include as ordinary income the excess of the fair market value of the stock on the date of vesting over the amount paid for the stock on the grant date, if any. For a startup company employee, paying tax as the shares vest may prove to be an insurmountable financial obligation, assuming that the value of the shares increases over time.
To avoid this outcome, the employee could file, within 30 days of transfer of the restricted stock, a Section 83(b) election with the Internal Revenue Service (IRS). If the employee timely files a Section 83(b) election, the employee recognizes ordinary income in the year of grant in an amount equal to the excess of the grant date fair market value of the stock over the purchase price paid for the stock, if any. If the employee pays the grant date fair market value for the stock and timely files a Section 83(b) election, no ordinary income would be realized as of the grant date and any future gain or loss recognized from selling the stock would be capital gain or loss. If the shares are held for more than 12 months, the employee may be eligible for long-term capital gain treatment.
Restricted stock or restricted units are but one of the potential options for providing equity to founders and initial employees. However, the benefits to the company and other owners provided by the restrictions on transfer, vesting and repurchase along with the favorable tax treatment make them an option worth considering.