Restricted Stock vs Options When We Are “Under Water”

You’d have thought we would learn our lesson with stock options. Back in the post-bubble era, I spent a lot of time on boards talking about granting new options to employees who are underwater. When the value of a company goes up too fast, and then comes back to reality (or overshoots it which is a common occurrence), the recently hired employees get screwed. As Alley Insider explains, 80% of Silicon Valley’s public companies have underwater stock options right now. Apparently over 1/3 of Google’s employees are under water on their stock options. The problem is not as bad in the privately held companies, and since the IRS came out with 409a, it’s become much easier to grant options at very low prices so I think privately held companies are not likely to face these same issues unless they are very profitable and/or very close to going public or having an exit.

There is another way to grant equity to employees. It’s called restricted stock. And I’ve become a big fan of restricted stock over the years. When comScore was preparing to go public in the spring of 2007, we had a long discussion about stock options versus restricted stock and adopted a plan that allowed the company to issue both, but in practice the company moved towards restricted stock grants and away from options. It was a good move. comScore’s stock, like most every other public company, is down and if they had issued stock options, all the options issued post IPO would be under water. Instead, the employees are in the same place as me and all the other shareholders, down but not out.

There’s a big psychological difference between owning stock that is worth less than it was and owning options that are underwater. When the stock market bottoms and starts moving back up, if you own stock you start making money again. If you own under water options, there’s a chance your options will never be worth anything. That’s not a good way to motivate employees.

Restricted stock has its own issues. When the employee gets a grant of restricted stock, he or she is getting real value that is taxable. Since the stock is restricted and the employee has to stick around for three or four years to earn it, there’s a vesting/repurchase feature that reduces the tax impact initially. And there are a number of ways to manage this tax impact for the employee but it is true that restricted stock is not the most tax effiicent way to grant stock. Stock options don’t face the tax issues upfront and are preferable for that reason.

I think restricted stock is a no-brainer for founders and early employees when the value of the stock is almost nothing. I also think its a no-brainer for public companies with marketable stock. The place where I am not yet convinced about restricted stock is privately held companies where the stock has real value but it is not yet liquid. In that situation, the tax issues with restricted stock make it less attractive than stock options. And with 409a in place, it’s now possible for privately held companies to issue options with strike prices that make them unlikely to get under water. So I think options are still the way to go with companies that are post startup/early stage and not yet public. But just make sure to grant the options with a strike that is as low as possible.

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