Startup Law 101 Series – What Is Restricted Stock?

Restricted stock is stock that is owned but can be forfeited if its holder ceases working for the startup.

The startup will typically grant such stock to a founder and retain the right to buy it back at cost if the service relationship between the company and the founder should end. This arrangement can be used whether the founder is an employee or contractor in relation to services performed for the company.

With a typical restricted stock grant, if a founder paid for it at $.001 per share, the startup can buy it back at $.001 per share.

But not forever.

The buy-back right lapses progressively over time.

For example, Founder A is granted 1 million shares of restricted stock at $.001 per share, or $1,000 total, with the startup retaining a buy-back right at $.001 per share that lapses as to 1/48th of the shares for every month of Founder A’s service tenure. The buy-back right initially applies to 100% of the shares made in the grant. If Founder A ceased working for the startup the day after getting the grant, the startup could buy all the stock back at $.001 per share, or $1,000 total. After one month of service by Founder A, the buy-back right would lapse as to 1/48th of the shares (i.e., as to 20,833 shares). If Founder A left at that time, the company could buy back all but the 20,833 vested shares. And so on, with each month of service tenure until the 1 million shares are fully vested at the end of 48 months of service.

In technical legal terms, this is not strictly the same as “vesting.” Technically, the stock is owned but can be forfeited by what is called a “repurchase option” held by the company.

The repurchase option can be triggered by any event that causes the service relationship between the founder and the company to end. The founder might be fired. Or quit. Or be forced to quit by intolerable circumstances. Or die. In any such case, the startup can exercise its option to buy back any shares that are unvested as of the termination.

Since such stock involves a “substantial risk forfeiture” that is tied to a continuing service relationship within the meaning of Internal Revenue Code section 83, an 83(b) election normally needs to be filed to avoid adverse tax consequences down the road for the founder.

We have been using the term “founder” to refer to the recipient of restricted stock. Such stock grants can be made to any person, whether or not a founder. Normally, startups reserve such grants for founders and very key people.

Why? Because a recipient of restricted stock is in fact a shareholder and has all the normal rights of a shareholder. Therefore, such grants should be used sparingly. Those who are not in the innermost circle of a startup will often get equity incentives in the form of stock options instead.

On the other hand, the stock granted to a founder need not be restricted stock. Grants may be made without strings to founders if desired. Normally, with a founding team, it is unwise to make unrestricted grants because any founder who simply walks away after receiving such a grant gets an equity windfall. Exceptions do exist, however, especially in the case of a major founder who has built such substantial value even before forming the company that it would not be fair to subject any of that founder’s shares to a risk of forfeiture.

If founders decide not to use restricted stock, or if they do and such stock has vested in whole or in part, VC investors will often require the founders to restructure their equity holdings at the time of a funding so as to subject them to a forfeiture risk. This means that even founders who are 100% vested will be made to redo their stock holdings so that they will be subject to vesting at least in major part.

Even at inception, founder grants can be mixed and matched. That is, there is no legal rule that says each founder must have the same vesting requirements. Even in the case of simultaneous grants made to several founders, one can be granted stock without restrictions of any kind (100% vested), another can be granted stock that is 20% immediately vested while only the remaining 80% of the grant is subject to vesting, and so one.

Vesting need not be over 4 years. Any time period will work, as long as the startup authorizes it by proper means.

Nor need vesting be monthly pro rata. It can be annual, quarterly, or any other increment. For founders, annual vesting is not normal since founders do not want a “one-year cliff” hanging over them as they build value in the company. In this sense, restricted stock grants differ significantly from stock option grants, which often have a cliff associated with them.

Founders can also attempt to negotiate acceleration provisions if termination of their service relationship is without cause or if they resign for good reason. If they do include such clauses in their documentation, “cause” normally should be defined to apply to reasonable cases where a founder is not performing proper duties. Otherwise, it becomes nearly impossible to get rid of a non-performing founder without running the risk of a lawsuit.

“Cause,” in the sense discussed here, should not be confused with the idea of “termination for cause” in an overall employment relationship. Normally, all founder service relationships with a startup should be terminable at will even if one of the consequences of that termination is that some or all of that founder’s stock vesting will accelerate. The issues are very different and should not be confused. Otherwise, the startup will run unnecessary risks of incurring a lawsuit whenever a founder is terminated.

VCs will normally strongly resist acceleration provisions, though they sometimes agree to them. They may seek to fashion them in a narrower way than founders would prefer, as for example by saying that a founder will only get some form of accelerated vesting in the event there is a change of control and the founder is fired within a stated period after the change of control (so-called “double-trigger” acceleration).

Restricted stock is normally used in the corporate format. It can be done via “restricted units” in an LLC membership context but is not often done so. The LLC is an excellent vehicle for many small company purposes, and for startups in the right cases, but tends to be a clumsy vehicle for handling the rights of a founder team that wants to use equity that can be forfeited. It can be done in an LLC but only by injecting into that vehicle the very type of complexity that most people who flock to an LLC seek to avoid. If it is going to complex anyway, it is normally best to use the corporate format for which it is best suited.

All in all, restricted stock is a valuable tool for startups to use as a way of setting up balanced founder incentives.