When dealing with equity for startup founders and employees, some of the primary concerns include how to best use the equity as compensation, as well as how to ensure that founders and employees remain loyal to the startup, and not just run off with a chunk of equity. Two of the tools that startups and big companies alike use to address these issues are stock options and restricted stock grants. Despite the similar sounding names, there are significant differences between the two, which we will discuss today.
The primary difference between restricted stock grants and stock options is that restricted stock is actual ownership of the stock, whereas stock options are merely an opportunity to purchase stock. Restricted stock is called restricted because over a certain period of time the company retains the right to repurchase the stock from the holder in the event he or she leaves the company (voluntarily or involuntarily); this right of the company is gradually lifted off of ever-increasing amounts of the stock in a process called vesting — vesting works by unrestricting a chunk of the stock after the founder or employee has served a period of time (usually a year, called the “cliff”), and then periodically unrestricting smaller chunks in annual, quarterly, or monthly periods (or you can even set event milestones, such as first quarterly profitability, $1m+ annual revenues, etc.). However, even though the stock is restricted, the holder still exercises all of the all rights of the stock, including voting rights or rights to dividends.
Stock options, on the other hand, are, as the name suggests, merely an option to purchase the company’s stock at a future date, at the fair market value price of the stock at the the time the option was granted. So, let’s say today I grant you 5-year stock options in my company; today the stock price is $1 per share; therefore, within the next five years you have the option to purchase the stock at $1, no matter what the price of the stock is when you actually purchase it. The hope is, of course, that within those five years the stock price will appreciate, so that you can purchase the stock at the lower price and realize the gain — if, for example, there’s a liquidity event in four years where the stock is valued at $10/share, you can exercise your options and sell the shares for a $9/share profit.
This reveals another fundamental practical difference between restricted stock and stock options startups, in that restricted stock is usually granted — that is, “sold” for nothing, or for a tiny fraction of a penny per share such that the total purchase amounts only to a few dollars (or in the case of founders, can be a nickel/dime/quarter per share such that each founder makes an initial capital contribution to the corporation with their initial stock purchase). Options, on the other hand, are normally issued once the company has generated value and its shares actually have a measurable price, such as a dollar; therefore the option holders must actually come up with the cash (which can be a significant amount for young entrepreneurs or key employees) to purchase the stock.
The other fundamental difference that results from this is the tax treatment of stock options and restricted stock. With stock options, aside from any income or payroll taxes which may be applicable, the tax on the gain from stock options is not realized until the gain itself is realized. On the other hand, holders of restricted stock must pay tax on the difference between the purchase price and the fair market value of the stock at the time when the stock actually vests. Since it usually takes years for restricted stock to fully vest, if a startup takes off it can result in significant tax liabilities (with potentially no liquidity to satisfy them). However, restricted stock holders have the option to file a Section 83(b) election with the IRS, which allows the holder to pay the tax on the difference between the purchase price and the fair market value of the stock *at the time of purchase* — for startup founders’ initial stock, this difference is usually going to be zero (unless the corporation is getting an initial capital contribution from a source other than the founders, which may mean that the corporation and therefore the stock has some fair market value that the founders must pay).