In a restricted stock program, employees are compensated with a number of shares of company stock subject to certain restrictions. Stock is usually nontransferable and subject to forfeiture under certain conditions. A company may require the employee remain with the company for a certain number of years before the shares are completely vested, or the vesting schedule may be tied to company or employee performance. Generally, with publically traded companies, employees do not pay for the restricted shares when they are granted. Regardless of how the company’s stock price fluctuates, the benefit almost always carries a monetary value when it vests.
Let me illustrate with an example: You receive a promotion to a high-profile position in your company. As part of your compensation package, you are awarded 15,000 shares of company stock with a vesting schedule over the next five years. After the first year in your position, 1,000 shares vest, meaning you will have full ownership of 1,000 shares. At your second anniversary, 2,000 shares will vest, and so on until your fifth year, when your remaining 5,000 shares vest. However, if you leave the company before the third year in your position, you forfeit 12,000 shares of unvested stock. Sometimes restricted stock is awarded each year. Therefore, if you leave the company, you leave some compensation on the table.
Restricted stock plans differ from stock options in that a stock option is only of value if the fair market value of the company’s stock is greater than the exercise price. For example, your company’s stock is selling today for $50 per share. Your company offers you the option to purchase 1,000 shares at that price with a one-year vesting period. In one year, you have the right to exercise your option to purchase the shares at $50 each. However, your option is only of value if the company’s stock price has increased to more than $50. With our restricted stock example, after one year, your 1,000 shares are worth their fair market value the day they are fully vested. Thus, a restricted stock plan may be the more coveted benefit. An equivalent number of restricted stock shares is almost always worth more than an option.
A restricted stock program is beneficial to the company in several ways. First, it reduces the cash compensation the employer pays out, therefore helping the company’s current cash flow. Second, it serves as an incentive to the employee, as a result of the vesting schedule. Third, restricted stock shares generally come with voting rights during the vesting period. Thus key employees should have a voice in decisions that shape the future of the company. Restricted stock also offers employees tax-deferred compensation as the shares are not taxed when granted unless otherwise elected. However, like most tax subjects, tax on restricted stock can be complicated, so I will cover that next week.
William G. Lako, Jr., CFP®, is an Executive in Residence at Kennesaw State University’s Coles College of Business and a principal at Henssler Financial. Mr. Lako is a CERTIFIED FINANCIAL PLANNER™ professional.