The Practical Tech Lawyer: Restricted Stock Basics

Restricted stock is a common way that companies put equity in the hands of their employees. Like stock options, the employee receives a grant (also called an award) from the company, in most cases he doesn’t pay anything for the grant, and usually it vests over time.  But there are important differences between stock options and restricted stock.

What is restricted stock?

Restricted stock is shares of a corporation, issued by the company to a service provider (an employee, director, consultant, advisor or other person), with restrictions on transfer and a risk of forfeiture until specified vesting conditions are met.

The shares are owned by the recipient beginning on the grant date, giving the recipient the right to vote the shares and receive dividends (although the award can stipulate that dividends will be held in escrow until the shares vest) and starting the holding period for capital gains purposes.

If the recipient leaves the company’s employment (or director services or other relationship, as applicable) before the shares vest, the company has the option, generally exercisable for several months, to take back the unvested shares, generally for no compensation or for a nominal payment.

This kind of restricted stock should not be confused with a different concept by the same name in the context of public companies. When outstanding shares of a publicly-traded company are not registered for resale and have no available exemption from the registration requirement, or are contractually restricted from transfer, these are also called “restricted” securities. I am not discussing those here.

How is restricted stock awarded?

State corporation laws require that any issuance of the corporation’s stock, including restricted stock, to be approved by the corporation’s board of directors or an authorized committee. While a shareholder-approved plan is not required for restricted stock awards of privately-held companies (as it is for incentive stock options), it is a best practice to have such a plan, and it is very easy to implement one.  In its authorizing resolution (by live meeting or unanimous written consent), the board or committee must determine (1) the number of shares and (2) the vesting conditions, and it is highly advisable for the board or committee also (3) to make a determination of valuation, even if it is confirming a valuation determined earlier.

How is it documented?

The company prepares a restricted stock agreement.  This includes:

- Vesting terms;

- A mechanism for the company to buy back the shares cheaply, or for no payment at all, if the recipient leaves the company before vesting;An escrow letter appointing a company officer, usually the secretary or treasurer, as escrow agent to hold the stock certificate until vesting (and the certificate for unvested shares should remain in the company’s control until then); and

- A stock certificate issued in the name of the recipient (but retained by the escrow agent until vesting). The stock certificate bears a restrictive legend that refers to the restricted stock agreement (which can be stapled for easy removal by the escrow agent at the time of vesting).

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SOLOWAy | Schwartz

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