Restricted Stocks Explained

Employee compensation is rapidly changing as employers compete to retain the best talent. During the COVID-19 pandemic, most companies offered at least one new employee benefit. The forecasted average compensation increase for 2022 is 4.12%.

Employee compensation may be direct, indirect, variable, or non-monetary. Over the last decade, employers, especially startups, have preferred to use restricted stocks and employee stock options for employee compensation.

Restricted stocks

Restricted stocks are unlisted shares that the company can transfer after fulfilling some conditions. Also known as restricted securities, these companies offer guarantees to corporate associates such as executives or directors. The requirements for transfer range from continuous employment for a predefined period to target earnings per share and fulfilling predetermined objectives.

Understanding Restricted Stock

Restricted stocks provide an employee with a stake in the company. Employers assign a fair market value to restricted stocks at the time of vesting. However, there is no tangible value till it vests.

The company sets up a vesting schedule and determines when employees obtain complete ownership of the asset. Upon vesting, the employee attains employer rights provided assets. Consequently, restricted stocks incentivize employees to perform well and continue with the company.

Types of restricted stocks

There are two variations to restricted stocks based on employee rights and obligations.

1. Restricted Stock Unit

   A restricted stock unit or RSU is a guarantee by the company to its employee to grant shares at a predetermined future date. RSU is subject to a vesting period and fulfilment conditions. Holders of RSU do not have any voting rights since these are not actual stocks. An employee must exercise RSU to access these shares.

2. Restricted Stock Award

   Restricted stock awards are similar to RSU, and a company issues these shares as employee compensation. Employees with RSA can enjoy voting rights immediately. Unlike RSU, employees cannot redeem the cash value of RSA at a future date.

Restricted Stocks vs. Stock Options

Restricted stocks and employee stock options are rather similar. Employee stock options give an employee the right to purchase company shares at a predetermined price within a prespecified timeframe.

The difference between restricted stock and stock options include:

• Value:

  Restricted stocks form part of the employee compensation and possess some value irrespective of the underlying market price. Stock options are worthless if the market price of the security is below the strike price during the exercise period.

• Tax Treatment:

  For restricted stocks, employees are liable to pay tax upon the transfer of ownership to the employee. Hence, the taxable value is a function of the market price at the transfer time. The tax treatment for stock options depends on its structure and varies from restricted stocks.

• Motivation:

  Restricted stocks motivate employees to achieve long-term goals set by the company during the vesting period. In contrast, stock options encourage employees to focus on short-term goals that may increase the security's market price.

Valuation of Restricted Stock

The equity valuation and outstanding shares of a company include its restricted stock. The value of restricted stock is the same as that of unrestricted stock, irrespective of the voting rights. Therefore, a company with restricted stock may overstate its market capitalization. The number of restricted stocks offered to employees tends to be lower than equity stock options, so the effect on market capitalization is minimal.

Features of Restricted Stock

Restricted stock has a few distinguishing features. These include:

1. Well-established and reputed companies offer restricted stock to high-level employees with the objective of retention and motivation.
2. Restricted stock is subject to a vesting period and prespecified conditions. Transfer of ownership is only after the accomplishment of these conditions.
3. Restricted stocks are subject to conditions to avoid an untimely and premature sale of shares and may be detrimental to the company.
4. Issuance of restricted stock is a common method for indirect and non-monetary employee compensation, especially during corporate events such as mergers and acquisitions. Occasionally, these shares are unrestricted if another corporation takes over the company and leads to employment termination.

Advantages of Restricted Stocks

Like any other stock, restricted stocks, too, have pros and cons. The primary advantages of restricted stocks are as below:

1. Employee Motivation:

   The transfer of ownership of restricted stock is subject to the accomplishment of performance-related targets. Hence, it is beneficial for the employee and the company.

2. Voting Rights & Dividend:

   Employees enjoy voting rights and dividends upon converting unrestricted shares into regular shares.

3. Stock Value:

   Restricted stock retains its value irrespective of the market action. Hence, the value of a restricted stock is higher than stock options. Also, stock options require a more significant number of shares to offer benefits that are at par with restricted stocks.

On the contrary, employees may be liable to pay additional taxes on restricted shares even if the security's market value reduces. There is no option to defer payment of taxes till the sale of the security. Furthermore, companies offer fewer restricted shares to employees and they may lose out in case of non-fulfilment of vesting conditions or exit during the vesting period.

Bottom Line

Restricted stocks serve as a highly efficient tool for employee compensation. It allows the employee to grow financially with the company. The circumstances of the company and employees determine the terms and conditions for the offer in the Stock trading app.