Startups often use equity to help attract and retain talented workers. This article outlines the differences and similarities of stock options and restricted stock awards and why most early stage startups that issue stock shortly after formation utilize restricted stock awards when compensating their workers.
What are stock options?
Stock options give employees the right to buy a specific number of shares of the company at a specified price (the “strike price“) during a window of time.
What are restricted stock awards?
Restricted stock awards typically vest over time, usually over a four year period for employees and two years for advisors.
If the worker or the advisor leaves the company before all of the stock has vested, the company has the right to repurchase the unvested stock.
How are stock options and restricted stock awards similar?
Both stock options and restricted stock awards encourage loyalty to the company by incentivizing the worker to remain with the employer for at least a minimum period of time.
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.
How are stock options and restricted stock awards different?
One key difference is holders of restricted stock awards own their shares from the date of the stock grant.
In contrast, stock options provide the holder with the opportunity to purchase the stock in the future. In addition, stock options typically have an expiration date and the worker can only exercise their options during a specific window of time.
What are the benefits to stock options?
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 shares is often only the par value of the shares. Thus the purchase price is typically very minimal.
Why are restricted stock awards often better than stock options for most early stage startups?
Each situation is unique, but most early stage startups use restricted stock awards rather than stock options for five reasons.
1. No Need For a 409(a) Valuation
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 that fair market value for restricted stock awards is the fair market value of the stock when it is purchased. Shortly after formation the stock usually does not have much value, so this is often the par value of the stock.
In contrast, the valuation of stock options is typically done by a professional valuation company (a 409(a) valuation) and can cost thousands of dollars. If the company uses restricted stock awards, this money can instead be spent on the company’s other priorities.
2. Stock Options Could Become Worthless
Also, a stock option could become worthless. For example, a stock option grant with a strike price of $10 has no value if the fair market value of the stock is later determined to be $8. In contrast, if restricted stock is granted when the stock is trading at $10 and is later worth $8, the stock is still worth $8 and has only lost 20% of its value.
3. Restricted Stock Awards Might Better Motivate Workers and Advisors
In addition, some workers and advisors 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.
Restricted stock, therefore, might better motivate some workers and advisors to think and act like owners of the company, take a personal interest in the company, and be more focused on meeting the company’s objectives because they will obtain shares regardless of whether the stock price goes up or down.
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 the options have no value. Because the value of the stock may not increase, the worker might not have the same amount of loyalty to the company as they would if they had been granted restricted stock.
4. Immediately Start The Clock Running For The Lower Capital-Gains Rate
If the worker makes an 83(b) election, the income from the restricted stock grant will be recognized at the time of the stock ”transfer” – its purchase date – rather than when the stock vests. The reason this is important is if an 83(b) election is made, the long term capital gains holding period also begins on the purchase date of the restricted stock rather than when the stock vests.
5. Workers May Be More Likely To Focus On The Long-Term Value Of The Company
Finally, a worker with stock options might be more motivated to increase the short term stock price so they can exercise their stock options. This may be to the detriment of 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 awards instead of stock options as they often provide a superior method of compensating and motivating workers and advisors.
We typically see this switch to stock options being the preferred tool for motivating workers and advisors after the company has raised its Series A round. At that point, the fair market value of the stock has gone up and it is more expensive to purchase.
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