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    Why are restricted stock agreements often better than stock option plans for most early stage startups?
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    Each situation is unique, but most early stage startups use restricted stock purchase agreements rather than stock options for three three reasons.

    1. No Need For a 409(a) Valuation.

    The board of directors is required to determine the fair market value of stock for both a restricted stock purchase agreement and for a stock option plan.

    The key difference is in a restricted stock purchase agreement, it is the fair market value of the stock when it is purchased, which for early stage startups is often the par value of the stock as the company does not yet have much value.

    In contrast, under IRS Regulation 409(a) if the the valuation of stock options is done by a professional valuation company, the valuation is assume to be correct and the burden is on the IRS to prove otherwise. However, if the company does not use a professional valuation company, if there is ever an audit it has the burden of proving the valuation is correct. This has lead to companies typically hiring an outside valuation firm to do the valuation of stock options. The thousands of dollars it costs to have 409(a) valuations completed, could instead be spent on other things for the company, such as software programming or marketing.

    2. Stock Options Could Become Worthless.

    Also, a stock option could become worthless. For example, a stock option grant with a strike price of $10 has no value if the fair market value of the stock is later determined to be $8. In contrast, if restricted stock is granted when the stock is trading at $10 and is later worth $8, the stock is still worth $8 and has only lost 20% of its value.

    3. Restricted Stock Might Better Motivate Workers.

    Also, some workers might be better motivated with restricted stock than with stock options because workers will get shares of the stock regardless of whether its value increases. In contrast, stock options are worthless if the value of the stock goes down or if the worker fails to exercise the stock option.

    Restricted stock, therefore, might better motivate some workers to think and act like owners of the company, take a personal interest in the company and be more focused on meeting the company?s objectives because they will obtain shares regardless of whether the stock price goes up or down.

    In contrast, stock options might do less to instill a sense of ownership because the worker could invest years in the company only to find that the value of the stock has decreased and so there is no value in the stock options. Because the value of the stock may not increase, the worker might not have the same amount of loyalty to the company than if they had been granted restricted stock.

    4. Workers? May More Be More Likely To Focus On The Long Term Value Of The Company.

    Finally, a worker might be more likely to be motivated to increase the short term stock price so they can exercise their stock options even if this comes at the detriment to the longer term growth of the company.

    For all of these reasons, most early stage startups use restricted stock instead of stock options as they often provide a superior method of compensating and motivating workers.

    Disclaimer: Content on this website is provided for informational purposes only and does not constitute a legal advice.

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