Restricted stock

Restricted stock is common stock granted to employees or executives as compensation, subject to a vesting schedule and typically transfer restrictions until vesting. Unlike options, restricted stock is actual shares from day one, so the holder votes and receives dividends on unvested shares; however, the shares are forfeitable if the employee leaves before vesting.

How restricted stock works

An employee is granted, say, 1,000 shares of restricted stock. On day one, they own those 1,000 shares — they are the legal owner, appear on the cap table, vote at shareholder meetings, and receive dividends. However:

• They cannot sell or transfer the shares until vesting is complete (subject to company trading windows and blackout periods).
• They are forfeited if the employee leaves before vesting is complete.
• They vest on a schedule, usually 4 years with a 1-year cliff, so 250,000 shares vest per year.

Once shares vest, they are unrestricted: the employee can sell, transfer, or hold them as they wish.

Restricted stock versus RSUs

The key difference is ownership and voting rights:

• Restricted stock: You own the shares from day one. You vote and receive dividends, even if unvested. You forfeit the shares if you leave.
• RSUs: You own nothing until vesting. You receive no dividends; you have no votes until shares settle. On vesting, shares are issued and you take possession.

RSUs became more popular in the 1990s-2000s because they avoid the complexity of restricted voting stock and are easier to administer for large companies. However, restricted stock remains common, especially in founder-friendly companies and in private companies.

Tax implications of restricted stock

In the US, restricted stock is taxed under Section 83 of the tax code:

• At vesting: The holder recognizes ordinary income equal to the fair market value of the shares on the vesting date, minus any price paid for the shares. If you were granted 250 shares at vesting and the stock is worth $100, you recognize $25,000 of ordinary income on that date.
• At sale: When you sell the shares, you recognize a capital gain or loss equal to the difference between your sale price and the fair market value on the vesting date.

This can create a tax-vesting mismatch: if restricted stock vests when the company is still private and valued at $10 per share, you owe income tax on that value, but you cannot sell the shares until the company is public. If the IPO happens years later and the stock is worth $50, you owe tax on the $10 value but have only book gains on the $40 appreciation. If the stock later crashes, you took a large tax hit for shares that declined.

83(b) election: To address this, employees can file an 83(b) election, electing to pay tax upfront (at grant, not vesting) on the restricted shares at the lower grant-date value. If the stock later appreciates, the appreciation is taxed as a capital gain. This is advantageous if you believe the stock will appreciate and you can afford the upfront tax.

Restricted stock in private companies

In private startups, restricted stock is common because it is simpler than RSUs for smaller organizations. Founders often grant themselves restricted stock with heavy vesting (or no vesting at all, if they own enough of the company) to lock in founders’ ownership.

When the startup raises venture funding, Series A investors often negotiate for founders’ shares to be put into vesting if they are not already (or to vest more slowly going forward). This aligns the founder to stay with the company.

Restricted stock versus common stock

The difference is solely the vesting schedule and transfer restrictions. Economically and legally, restricted stock is common stock with strings attached. Upon vesting, it becomes unrestricted common stock with no ongoing restrictions.

Use in public companies

Large public companies including Google, Amazon, and Microsoft grant restricted stock (or more commonly, RSUs) as a major part of executive compensation. The advantage over options is that the grant has intrinsic value from day one (it is worth the stock price), whereas options are only valuable if the stock appreciates. This makes restricted stock more suitable for attracting risk-averse executives.

Dividend treatment

Dividends on restricted stock are typically reinvested or withheld in the restricted account until vesting. Some companies allow the employee to take cash dividends; the tax treatment varies. This is typically negotiated in the grant agreement.