The Shadow CEO:
Equity Beyond Stock Options—Restricted Stock and More

Entrepreneur, investor, and corporate governance authority Dennis Cagan shares insights on seldom-taught things an entrepreneur needs to know about equity and governance—before making needless mistakes—in The Shadow CEO series.

Part 6: Restricted stock and more

The Shadow CEO is an ongoing series with tips for entrepreneurs from serial founder and high-tech industry veteran Dennis Cagan, who has served on sixty-seven for-profit corporate boards, including ten publicly traded companies.

Many first, second, and even third-time founders get themselves into bad situations that could be avoided if they knew more about how corporate governance and equity distribution worked in early-stage companies.

Whether you hope to eventually sell your start-up to a larger firm or navigate through an IPO, if you plan on taking in investors—friends and family, angels, venture capital, or strategic corporate investors—you need to understand how to protect yourself and your management team.

The segments in this ongoing series can not only save you time and energy, but they could result in making—or saving—you millions of dollars.

Restricted stock and more

While stock options are the most common type of equity compensation granted by companies to their employees and executives, other types of grants have meaningful advantages under certain circumstances, particularly for very early-stage and much later-stage organizations. Two of the most popular stock incentive structures today are the restricted stock award (“RSA“) and the restricted stock unit (“RSU”). Let’s contrast these to help you understand which may be better for you, when, and why.

The primary difference between stock options, RSAs, and RSUs is that the latter two are not options. They are actual awards of stock, or the right to take possession of stock – not options to buy. The RSA can be of particular value to a very early-stage venture that has not yet taken in any equity capital (promissory notes do not count here) or established an enterprise value that would require the board to set a FMV above the original par value of the shares, or some other minimal price. This allows the awarding of restricted shares without triggering a significant tax obligation on the part of the recipient.

The RSU can be of value to a later-stage company that already has a relatively high established FMV per share price, where the award of actual shares would trigger a significant tax obligation on the part of the recipient. Since a RSU is ‘synthetic’ or ‘phantom’ equity and does not represent actual ownership. its award does not usually trigger a taxable event.

Both are termed ‘restricted’ because while RSA shares are actually given, and RSU shares are actually promised, they both carry some condition or restriction. This restriction is the right of the company to either buy any unvested RSA shares back upon the employee’s termination or not actually deliver any unvested RSU shares should the employee be terminated or fail to meet other award conditions. In this context, the shares do not actually vest, but rather, their restrictions expire over the ‘vesting period’, or when the employee meets the award’s milestones.

Restricted stock units

Restricted stock units are a way an employer can grant company shares to employees. The grant is “restricted” because it is subject to a vesting schedule, which can be based on length of employment or on performance goals, and because it is governed by other limits on transfers or sales that your company can impose. In essence, since these shares are promised and not actually delivered, it does not usually trigger a taxable event. The recipient typically receives the shares after the vesting date. Only then do they have voting and dividend rights. Companies can and sometimes do pay dividend equivalent payouts for unvested RSUs. Unlike actual dividends, the dividends on restricted stock will be reported on W-2s as wages, unless one made a Section 83(b) election (see below).

Unlike stock options, RSUs always have some value, even when the stock price drops below the price (FMV) on the grant date.

In some cases, particularly for higher-ranking executives, RSUs can also be tied to performance goals either individually or at the corporate level, and they can also contain covenants that can terminate the RSUs if the employee is terminated for cause. Generally, an RSU represents stock, but in some cases, an employee can elect to receive the cash value of the RSU in lieu of a stock award.

Once RSUs are exercised and become actual shares of the company’s stock, those shares come with standard voting rights for the class of stock issued. However, before the RSUs are exercised they carry no voting rights. This makes sense because the RSUs are themselves not actually stock, and therefore don’t carry the same rights inherent to the stock itself.

RSUs are taxed as ordinary income as of the date they become fully vested, using the FMV of the shares on the date of vesting.

Restricted stock awards

RSAs are like RSUs in many ways but have their own unique differences as well. Like RSUs, restricted stock awards are a way for the company to reward employees with stock in addition to their standard cash compensation. Restricted stock typically vests over time and can be subject to forfeiture if the employee is terminated, quits, or fails to meet any performance objectives as stipulated in the stock award program.

However, the similarities largely stop there. Restricted stock awards come with voting rights immediately because the employee immediately owns the stock the moment the award is granted. This contrasts with RSUs, which represent the right to stock, as opposed to owning the stock but with restrictions. Also, restricted stock awards cannot be redeemed for cash, as some RSUs can be.

The tax treatment of restricted stock awards comes down to a choice by the employee. The employee can pay taxes similarly to an RSU award, with the fair market value of the restricted stock counted as ordinary income over time as it vests. However, this can require annual filing and some amount of tracking and paperwork. Thanks to an IRS rule called Section 83(b), restricted stock award holders can also elect to pay the ordinary income tax based on the FMY of the stock on the day it is granted. This feature is beneficial to many highly compensated executives because it provides them with greater choice in their tax planning.

Sometimes, restricted stock awards require that the employee pay a certain amount to accept the restricted stock. In essence, the employee is paying for the shares, typically at a discount. This structure can reduce the tax burden for the employee because the taxes paid on the restricted stock award will be based on the difference between the value and the amount the employee paid, instead of the total value of the stock.

For employees without lower incomes, this requirement can be a major issue with restricted stock awards. This is part of the reason why with many companies, the RSUs have gained popularity in recent years, especially with firms with higher share values.

While similar in most regards, the differences between RSUs and restricted stock awards can have a major impact on how valuable a stock bonus can be. It’s critical to consult with an accountant who has experience with various stock award structures to ensure you maximize the value of your RSUs or restricted stock based on your own personal situation.5

IRS form 83(b)

It is important to remind people that when they get something of value, the Internal Revenue Service wants its share—typically on the April 15th following the end of the year in which the gain was realized. Whereas, with stock options, no value is received by the awardee until they exercise the options, pay the strike price, and take possession of the shares. Note the description of ISOs and NQSOs above.

And, in the case of an RSU, similarly, the recipient does not take possession of the shares until all the conditions have been met. However, in the case of RSAs, the actual ownership of the shares of stock are transferred to the individual – albeit with the condition that the company has the ‘right’, but not the obligation, to buy it back, on some pre-determined terms, if the full term or conditions are not met. Shares awarded with an RSA have the full rights of their class – e.g., voting, dividends, etc. Since this means that the person has received value, that value is taxable. If, on the award date the stock had a par value of say $0.001 or $0.01, then for that year a person receiving 1,000 RSAs would owe tax on $1.00 or $10.00 as ordinary income.

Then, each year after that, the person would owe tax on the increasing value of those shares and additional vested shares. If they failed to meet the conditions of the award, and do not receive some of the shares, there are no tax refunds. In order to help citizens avoid the inconvenience of reporting these annual increases in income, the IRS has provided an exemption.

The taxpayer may complete a Form 83(b) and submit it to the IRS. It is a very brief form that simply details the terms of the grant. With this form now on file, the next tax period the taxpayer pays any tax due on the actual value of the shares received but does not pay anything else until the shares are ultimately sold. IRS waives the necessity of annual taxes on the increasing value of the award and postpones any further taxes on this until the shares are sold. At that time the taxpayer reports the difference between the original value stated on the 83(b)—which they previously paid the tax on, and the selling price.

Caution: an individual only has thirty days from the date of the award to file the form. Many have missed this detail and subjected themselves to a lot of unnecessary tax-filing headaches. As always, check with your accountant, CPA, or financial advisor for advice regarding your specific circumstances.

Part 7 continues the series.

Note: The information provided in this article does not, and is not intended to, constitute legal or tax advice; instead, all information, content, and materials available below are for general informational purposes only.  Information in this article may not constitute the most up-to-date legal, tax, or other information. Readers should contact their attorney or CPA to obtain advice with respect to any particular matter. The views expressed here are those of the author writing in his individual capacity only.


PART 1: Early-Stage Insights for Entrepreneurs

PART 2: Deciding to Distribute Startup Equity? Here’s a Founder’s Guide

PART 3: Using Equity as an Incentive and the Role of the Board

PART 4: What Entrepreneurs Need to Know About the Foundational Documents of a Corporation

PART 5: Equity Distribution Techniques

PART 6: Equity Beyond Stock Options

PART 7: Stock Classes and Raising Capital

PART 8: Determining Startup Value

PART 9: Explaining Common Metrics

PART 10: Calculating Share Price

PART 11: Protecting Founders and Special Voting Preferences

PART 12: Additional Equity Grants

About the author:

Dennis Cagan, a noted high-tech entrepreneur, executive, and board director, has founded or co-founded more than a dozen companies and served as CEO of both public and private companies. The venture capitalist, private investor, author, and consultant, is a long-time board member of some 67 corporate fiduciary boards. In his Shadow CEO® role, he steps in side-by-side with a CEO to help them navigate circumstances and situations on a day-to-day basis.

A version of this column was previously published in Cagan’s “A Primer on Early-Stage Company Equity.”

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Dennis Cagan, a noted high-tech entrepreneur, executive, and board director, has founded or co-founded more than a dozen companies and served as CEO of both public and private companies. The venture c(...)