What Is Restricted Stock?

Restricted Stock Explained

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Restricted stock is compensation employers give to their employees in the form of equity ownership. It’s “restricted” because there are limitations on when the employees have full ownership rights to the shares, usually tied to a vesting schedule or achievement of a performance metric. It allows employers to attract top talent and retain key executives without increasing the company’s cash requirements for traditional salary.

There are different types of restricted stock, and every plan may have slightly different rules, depending on the employer. Here’s a detailed general explanation of restricted stock, how it works, and what it means to the individual investor.

Definition and Examples of Restricted Stock

Restricted stock, also referred to as restricted stock units (RSUs), is a type of equity compensation through which a company pays its employees in shares of stock. The stock is “restricted” because it is often accompanied by a vesting schedule before the employee has full ownership of the stock. Once the vesting schedule requirement is met, the company then distributes the stock to the employee, either in shares or cash equivalents, depending on plan rules.

Companies offer restricted stock to their employees to attract top talent, lower cash requirements for the company, retain key employees and executives, and align the employees’ incentives with the business’s success.

For example, a new tech startup might offer restricted stock to its key executives to provide additional compensation without the need for immediate cash. In addition, the stock may have a vesting timeline of five years before the executive has full ownership of the shares. The vesting schedule gives the executive an incentive to stay longer and work in the best interests of the company’s success.

How Restricted Stock Works

Restricted stock plans give employees of a company a personal interest in how well the company does. The vesting schedule of restricted stock units is usually dependent on length of employment or based on performance goals being met. Once you are fully vested, you have voting rights and possibly dividend payments with the shares you are granted. 

For example, your employer may grant you 3,000 shares of restricted stock in an agreement that states you will be fully vested after five years of employment (vesting a 20% portion per year) or if you meet specific performance goals. After you are fully vested, you now have full voting and dividend rights with the shares you were granted.

You are taxed on restricted stock units when the shares are delivered to you, which is almost always once you are fully vested. Therefore, your taxable income from restricted stock units is the market value of the shares at the time of vesting—and is taxed as ordinary income.

Continuing the example above, let’s say the 3,000 shares are priced at $10 per share. After five years, you are fully vested, and the current stock price per share is $30. Your taxable income would be based on the price per share at vesting or $30 per share, times 3,000 shares, which equates to $9,000. 

If you received cash equivalents, you’d pay taxes in the year you received the cash. However, if you were compensated in actual company shares, you would be taxed once you sell the shares. In addition, it is possible to pay capital gains taxes if the price per share has increased between the time you received the shares and the time you sold them.

Should you leave your employer before the vesting schedule has lapsed, you likely will forfeit your interest in the compensation plan.

Types of Restricted Stock

There are two types of restricted stock. They are restricted stock units (RSUs) and restricted stock awards (RSAs). Both are stock compensation plans given to company employees that have certain restrictions to be met before the stock can be delivered to the employee. The difference between the two lies in what those rules are and when the shares are granted to employees.

Restricted Stock Units (RSUs)

RSUs are stock ownership as a form of compensation offered to employees and are issued on a defined vesting schedule. In most cases, the employee must work for the company for a specified time before he or she can have full rights of ownership of the stock. Depending on the plan rules, employees may choose to receive their RSUs in stock shares or cash equivalents equaling the value of the shares at the time of delivery.

Restricted Stock Awards

RSAs are very similar to RSUs. They are a type of additional employee compensation that also comes with rules and restrictions, such as a vesting schedule. However, rather than being part of a long-term compensation plan often laid out in an employment offer letter, RSAs are “awarded” to employees much like a bonus. 

The most significant difference between RSUs and RSAs is that no company stock is issued at the time of an RSU grant, whereas with RSAs there is stock granted to the employee at the time they are awarded. Because of this, employees who get RSAs don’t have the option for special tax elections that often come with RSUs.  

Restricted Stock vs. Stock Options

Restricted stock and stock options are some of the more popular equity compensation plans offered by employers. What’s the difference between the two?

Restricted Stock Stock Options
Restricted stock involves actual shares of stock you are allotted for ownership based on a vesting schedule laid out in the plan details. When you own stock options, you don’t actually own shares of a company but rather a contract that gives you rights to purchase shares at a future date.
Restricted stock always has some value to you, even if the price goes below the price at which they were given to you. Stock options can expire worthless if they aren’t exercised before the expiration date.
You are taxed at the value on the date they were granted to you. You may pay capital gains tax if you sell your shares and realize a gain from the date the shares were granted to you. There are different tax treatments for stock options. Depending on the type, you are either taxed on the growth of the stock as a long-term or short-term capital gain, or you are taxed as ordinary income, once shares are exercised.

What It Means for Individual Investors

How a company compensates its employees is a vital piece of information that can be an indicator of future company success. Restricted stock can be an excellent way for companies to include their employees in the overall ownership of the company and its performance. In addition, a generous company culture is a positive indicator when looking for good investments. Including employees in the ownership of the company and its success is a time-honored way to boost company morale. 

As an investor, it's also wise to understand different equity compensation plans a company offers because it can significantly affect a company’s balance sheet and future payroll obligations.

Key Takeaways

  • Restricted stock is a type of equity compensation plan offered by employers in which employees are granted stock but only gain full ownership after specific requirements are met, such as a vesting schedule or achieving performance metrics.
  • There are two types of restricted stock: restricted stock units (RSUs) and restricted stock awards (RSAs).
  • Restricted stock differs from stock options in that restricted stock equals shares of ownership, and stock options are contracts to purchase shares of stock at a future date. As a result, each has different tax implications.
  • Investors analyzing a company to add to their portfolio are wise to consider the equity compensation plan offered by companies so they can determine how it might affect the company culture and the balance sheet.