Restricted stock options startup
Startups often use equity to help attract and keep talented workers. This article outlines the differences and similarities of stock options and restricted stock purchase agreements and why most early stage startups which issue stock shortly after formation select restricted stock when compensating their workers.
Restricted stock vests overtime, typically over a four year period. If the worker leaves the company before all of the stock has vested, the company has the right to repurchase the unvested stock back from the worker. In addition, both provide an important tool to startups that may not have much cash to attract top talent.
Finally, both encourage the worker to increase the value of the company, which creates a unity of interest between the worker and the employer. One key difference is restricted stock vests over time regardless of whether the value of the stock increases. In contrast, stock options do not automatically vest. Instead, stock options have an expiration date and the worker can only exercise their options during a specific window of time.
With stock options the worker is not out any money if the stock price does not rise because they can decide not to exercise the stock options. That being said, for new startups the fair market value for restricted stock is often only the par value of the shares and so the purchase price is typically very minimal.
Each situation is unique, but most early stage startups use restricted stock rather than stock options for five reasons.
The board of directors is required to determine the fair market value of stock for both restricted stock and stock options. The key difference is for restricted stock it is the fair market value of the stock when it is purchased, which for very early stage startups is often the par value of the stock as the company shortly after formation does not yet have much value. In contrast, under IRS Regulation a if the the valuation of stock options is done by a professional valuation company, the valuation is presumed to be correct and the burden is on the IRS to prove otherwise if there is ever an audit.
However, if the company does not use a professional valuation company, if there is ever an audit the company and not the IRS has the burden of proving the valuation is correct.
The thousands of dollars it costs to have a valuations completed, could instead be spent on other things for the company, such as software programming or marketing.
After a company has gained value the valuation of grants of restricted stock is no longer par value, but for an early stage start it is much easier, and less expensive, to properly determine the value of restricted stock than it is stock options.
Also, a stock option could become worthless. In addition, some workers might be better motivated with restricted stock than with stock options because workers will get shares of the stock regardless of whether its value increases. In contrast, stock options are worthless if the value of the stock goes down or if the worker fails to exercise the stock option. In contrast, stock options might do less to instill a sense of ownership because the worker could invest years in the company only to find that the value of the stock has decreased and so there is no value in the stock options.
Because the value of the stock may not increase, the worker might not have the same amount of loyalty to the company than if they had been granted restricted stock.
Finally, a worker with stock options might be more likely to be motivated to increase the short term stock price so they can exercise their stock options even if this comes at the detriment to the longer term growth of the company.
For all of these reasons, most early stage startups which issue stock shortly after formation use restricted stock instead of stock options as they often provide a superior method of compensating and motivating workers. Please contact us at or info bendlawoffice.
No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this article. Bend Law Group is a San Francisco law firm of experienced small business attorneys and startup lawyers.
Home About Services Blog Press Contact. What are stock options?
Startup Negotiations: How Preferred Stock Makes Employee Stock Less ValuableSTOCK OPTION COUNSEL
What is restricted stock? How are stock options and restricted stock similar?
Restricted Stock Is Better Than Stock Options
How are stock options and restricted stock different? What are the benefits to stock options? Why are restricted stock agreements often better than stock option plans for most early stage startups?
No Need For a a Valuation.
Stock Options Could Become Worthless. Restricted Stock Might Better Motivate Workers. Immediately Start The Clock Running For The Lower Capital-Gains Rate. Suite San Francisco, CA Subscribe to BLG Blog: