Equity Compensation

The Human Capitalist Series P.4: Restricted Stock Awards

A stock purchase award (also known simply as “restricted stock”) is the sale of a share of stock in exchange for an actual cash payment (or transfer of property with a fair market value that equals the purchase price and which property is not already the company’s). A stock purchase right is best thought of as “early exercising” an NSO. That is, the service provider is purchasing stock very shortly after the grant date, paying cash for the shares, withholding taxes on any spread, and, if the award is unvested, typically filing an 83(b) election.

The stock purchase right can be granted subject to vesting, or it can be granted fully vested.

NOTE: if someone has provided services for which the company has not paid cash to the individual, paying in stock does not relieve the parties from withholding taxes on the value of stock paid on the services or reporting the value of the stock on the W-2/1099 at the end of the year. For instance, if an employer pays an employee a bonus in stock, the employer still has to report the compensation to the IRS and withhold cash from the employee for the applicable withholdings. Paying for services in stock is not a cash-free transaction. Furthermore, if someone is paid a salary for their services, it would be difficult to then argue that those same services were rendered in payment of the purchase price of stock.

General Pros and Cons of Stock Purchase Awards

  • Pro: Stock purchase awards are theoretically exempt from Internal Revenue Code Section 409A.
  • Pro: They are useful while the stock price is low enough that employees can afford to pay full price.
  • Pro: The qualified small business stock (QSBS) and capital gain holding periods begin at purchase.
  • Pro or Con: Stock purchase awards result in stock ownership at purchase (not a derivative security like options).
  • Con: They require an upfront payment by the recipient.
  • Con: If stock purchase awards are granted unvested, the Section 83(b) election must be timely filed and received by IRS, or else the recipient is taxed on each vesting date. Taxes are due immediately on the vesting dates—so the withholding obligation can be difficult to manage and extremely expensive as value rises.
  • Con: It may be difficult to determine the taxes due at vesting if a current fair market value determination can’t easily be made (e.g., after a prior Section 409A valuation is no longer valid).

Accounting Treatment—Stock Purchase Awards

The value of a stock purchase award that has time-based vesting is measured on the grant date based on the number of shares subject to the award and the current fair market value per share of stock. This value is recognized for financial statement purposes over the vesting period as a non-cash compensation expense.

How to Prepare for an Equity Financing

We have covered in past FTTWs how to value your startup and how much capital to raise. Once your startup decides to pursue equity financing, you should start to prepare for the investor due diligence process. On the business side, you will need to prepare a business plan and should take steps such as obtaining management references, interviews and background reviews, customer/user references, technical/product reviews, financial statements and business model reviews.

What Every Startup Needs to Know

On Wednesday, June 26th, Perkins Coie’s Palo Alto office hosted the startupPerColator event, “What Every Startup Needs to Know.” Lowell Ness, a Perkins Coie partner in the Emerging Companies & Venture Capital (ECVC) practice, moderated a panel which included Herb Stephens of NueHealth, Thomas Huot of VantagePoint Capital, Jennifer Jones of Jennifer Jones and Partners, Yuri Rabinovich of Start-up Monthly, and Olga Rodstein of Shutterfly.