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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Comments (Archived):

  1. DGentry

    Did you see any impact from the stock option expensing requirements added a couple years ago? Were stock options a more attractive option before that?At the time there were predictions that having to show option grants as an expense would make them impractical, and public companies would move to restricted stock grants exclusively. In Silicon Valley at least that does not seem to have happened, options are still quite common. I suppose this might be psychology at work: new employees may simply expect option grants, and lack of stock options would be a recruiting problem.

    1. fredwilson

      yes, now both options and restricted stock create comp expense. it used to be that options did not need to be expensed but as you point out, that’s changed.when you do the math, it’s not a big difference between the two anymore.

      1. DGentry

        What I mean is: did you notice a change when the expensing rules went into effect? Did more companies approaching IPO choose to convert to restricted stock grants because of the new expensing rules for options?There was much sound an fury at the time that FASB was going to destroy the technology industry with its new rules. The argument, deliberately taken to extreme, was that employees would be completely unmotivated to create new products.So far as I can tell, the expensing rules had no impact on the behavior (or results) of public companies. Companies continue to grant extensive options, and continue to emphasize their pro-forma results which exclude all of the annoying details they wish to bury.

        1. fredwilson

          You are right that the hue and cry and predictions of the end of innovation were way overblownStartup and tech companies still grant equity generously (thankfully) and it’s still an important, actually critically important, part of the startup cultureBasically, startup and tech companies just report earnings on an adjusted EBITDA basis now to show their true cash earnings minus all the silly accounting issues that have been foisted on the sector

          1. Blunder

            I talk to public institutional investors about expensing options under FASB 123R pretty often. Without exception, these people back out the related expenses when performing their analyses. Finance 101 says that the value of an investment is the present value of the cash flows returned by the investment. Options expense at the time of grant is non-cash ergo it doesn’t matter. They have always factored in dilution of additional shares as options are exercised. I think that it is fair to say there has been little impact on option granting policies because investors don’t care.The good news is that every company that grants options has to go through all the gymnastics and expense of determining their options expense number that no one cares about. Another example of accounting complexity benefiting no one except the accountants.

          2. fredwilson

            Totally agree

        2. mccv

          It definitely affected our company. Right now we’re in sort of a transition period… but whereas two years ago you only got restricted stock if you were a director+ (in an engineering company), now you get some restricted/some options if you receive an above average grant. It’s been almost universally well received by the people who get it. Fred is right on re: the psychological difference.One nasty side effect of underwater options is that they create a long-term demotivator. We have people with options granted in 2000 that are still underwater, and it’s a constant reminder that things aren’t what they used to be. In many cases it’s also a reminder that people had six or seven figure paydays that they missed.

  2. vantelimus

    I’ve done restricted stock purchase as a founder a couple of times now. It is tax efficient (with an 83(b) election) and confers immediate voting rights, something options do not do. Barring really bad advice from counsel, I cannot understand why founders would be handled any other way.For non-founders, however, one should consider the consequences of employees owning shares outright vs. holding non-exercised options. Once a non-founding employee owns shares s/he has rights to shareholder information and rights to vote. Of course, a non-founding employee’s shares would be small and their vote would not likely decide any issue. However, I would worry about the distractions caused by increased employee involvement in structure and funding issues. It is my experience that this kind of information often confuses even bright employees whose domain of expertise is not business. The distraction would be worse if they felt they must develop an opinion about a specific matter.

  3. flycaster

    I agree with your premise – restricted stock is not the most tax efficient means for granting stock, but it does allow you to deliver full value without the onerous strike price charge. True – the holder pays ordinary income tax on the value when the restriction lapses, but that may be better than paying tax on long term capital gain that, in the end, is far lower after the strike charge. Later stage startups suffer from high strike prices, which is an inherent demotivator for those in the know.

  4. Guest

    Fred,you just blew me away. Everyone I talked to says that before 409A the Boards had (almost) full discretion on strike prices, however, 409A is explicit that the strike price must be the fair market value of the underlying security, even for companies that are not readily tradable on an established stock exchange. It is true that they are a bit more lenient to startups, however, you still need an independent determination of fair market value, as opposed to before when the Board could decide whatever they wanted.Your post almost reads that 409A gave VCs the right to make up strike prices as they seem fit. Am I missing something? Perhaps you meant to say that amendments in 2007 loosened the requirements for startups a little bit, relative to the initial regulation from 2005?

    1. fredwilson

      What I am saying is the firms that do the 409a valuations can be bought and are boughtThe IRS totally screwed up. Before it was a fiduciary issue for boards. Now you just pay someone to say what you want them to say.It’s stupid but is better for the startups and their employees

      1. Guest

        … And the “Straight Talk Invessss” Grand Prize for candor among the VC community goes to……Fred Wilson from USV!!!

      2. Yuri Ammosov

        Fred: are there businesses that sell such service? Can you recommend any?

  5. rh0dium

    Great article – but I think your missing the implications of “everyone” being underwater. I think companies which have doled out stock options should really be thinking about retention rates right now. As an engineer who is “worthless” I no longer have a vested interest in the long term prospects of my company. Why wouldn’t I shift to greener pastures where their stock is also worthless but can only go up??

  6. LGBlueSky

    How would you recommend that the tax impact be managed for a restricted stock grant to a founder?

    1. fredwilson

      Ideally exchange something of value you own like a patent or trademark or domain name for the equity. Then its not taxable. But please don’t rely on me for tax advice. There are plenty of people who know this stuff better than me

  7. John Draper

    Fred – great article. Thanks.