Stock Restriction Agreement: Everything You Need to Know
A stock restriction agreement is an agreement made between a company and its founder for allotment of stock that places certain restrictions on its transfer.3 min read
A stock restriction agreement or SRA refers to the agreement made between a company and its founder for allotment of stock that places certain restrictions on its transfer.
What Is a Stock Restriction Agreement?
The founders of a new company are usually compensated through cash and stock. Since most new companies do not have enough cash, they often partially pay the founders with the stock of the company issued over a certain period of time. This is typically done under a stock restriction agreement (SRA).
If the founders are allotted all of their shares outright, investors may find it unattractive and may refuse to invest in the company. Hence, most founders execute a stock restriction agreement in order to protect the interests of the company and appease the investors. Under an SRA, the total amount of stock allotted to a founder is kept aside. A vesting schedule is prepared, and the shares are distributed in installments according to this schedule.
An SRA usually requires a founder to maintain a business relationship with the company until all of the stock is vested. If the founder leaves the company or is terminated before completion of the vesting schedule, the remaining unvested shares are forfeited.
The objective of an SRA is to provide an incentive to the founders to continue working on the company's product or service and contribute toward its success. Founders looking to enter into an SRA should consider retaining a lawyer because such agreements involve important aspects of tax and securities regulations.
Section 83(b) Election Under the IRC
Section 83(b) of the Internal Revenue Code (IRC) allows a founder to include the allotted stock in his personal tax return at the time of allotment instead of the time when it vests. This protects the founder against any increase in tax liability if the stock value goes up during the vesting period. The founder can claim all of the stock under the agreement in a single financial year. Any increase in the value of stock can be computed as capital gain at the time of actual sale. Note that 83(b) election must be made within 30 days of allocation of stock.
What Type of Stock Do Founders Receive?
When a company allocates stock to its founders, they typically receive shares in the ownership or common stock of the company. Therefore, all the rules under the state statute applicable for stock transfer usually apply to such allocation. As the company grows and expands its investment base, it may decide to issue preferred stock with additional rights, making it more attractive to investors compared to the common stock.
The Benefits of Vesting Agreement for Founders
When two or more people found a company and split up the common stock equally without any stock restriction or vesting agreement, they may inadvertently expose themselves to certain risks from each other. For example, one of the founders may abandon the company while still retaining his ownership interest. When other founders make the business a success, the abandoning founder may reappear to claim his ownership in the company.
Even if things don't reach this extreme, other similar issues may crop up. For instance, one of the founders may not show the same enthusiasm or not work with same dedication as the others. Executing a vesting agreement protects other founders from such potential risk.
How Does a Restricted Stock Agreement Work?
A typical restricted stock agreement works as follows:
- A founder is allocated unvested shares outright.
- A vesting schedule is prepared for the issuing of shares over a period of time.
- The company retains a right to repurchase the unvested shares for a certain amount if the founder terminates his relationship with the company.
- As shares vest, the company automatically loses the right to repurchase the vested shares, giving an exclusive ownership to the founder.
What Is a Vesting Schedule?
A vesting schedule is the period over which the unvested shares of a founder would vest. This period is decided by the company depending upon the role and contribution of each founder. A vesting schedule typically includes the date of installment along with the number of shares to be granted. Instead of a pure time-based schedule, companies may also tie the vesting to performance milestones.
A company should come up with its own vesting schedule to suit its investors. In its simplest form, a vesting schedule could be a four-year period with 25 percent of the total shares vesting each year.
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