Massachusetts Business Law: Restricted Stock as Employee Compensation in Massachusetts Privately Held Corporations

XYZ Corporation, a Massachusetts star-up corporation opened its doors three years ago. It has revenue of just over four million dollars, sales are strong, R&D is flourishing, but cash flow is tight, and the business is not yet profitable. The founders do not have the business experience to deal with the day –to-day and long term financial issues. They wish to hire Mr. Smith, a seasoned CFO to come in and take over the financial side of the operation, but don’t have the money to pay him.

In this scenario, some businesses will opt for a compensation package which will include restricted stock compensation, (stock which is subject to forfeiture or repurchase at the award price), in order to lure the prospective executive employee.

Is this a good idea? The answer is, that it depends. There are a number of factors that go into the equation and each situation is unique.

The fist question that must be asked is, “who am I bringing in as a shareholder”? Under Massachusetts business law every stockholder stands in a fiduciary relationship to every other shareholder in the company. As the Massachusetts courts have interpreted the fiduciary duty rule, it means the “duty of utmost good faith and loyalty” to one’s fellow stockholders. Accordingly, that means that the utmost duty of loyalty will apply not only to those who have either founded or funded the venture but also to a new, and presumably untested, stockholder employee.

The control in this situation is that the stock is restricted by contract. What that means is that if the employee ceases employment with the company during some defined period from the date of hire, the stock must be returned. It may be subject to forfeiture or the agreement under which the stock is issued may provide for some other formula for the company to repurchase.

The agreement then becomes key to the rights of the stock recipient. In many agreements, the stock will only be subject to forfeiture if the employee voluntarily terminates employment or if he is terminated for cause. Thus, if, for instance, the company cannot afford the employee, the company may be faced with a situation whereby it must repurchase the stock at value or leave the stock in the hands of a now “former” employee. It should be noted also, that once an employee receives stock compensation, (as opposed to stock options, which will be the subject of another article), he will have the same rights as a stockholder as the founders, and his termination as an employee may be held to much greater scrutiny by a court.

The risks diminish considerably if the restricted stock compensation is offered to a long term employee, who is a known quantity. In that case, (as in the case of options), it is important to make the employee aware that all stock and options have accompanying tax consequences, either in the year received or at another point in time. Typically, for restricted stock, upon election, the stock will become taxable only once a “substantial risk of forfeiture” is lifted, or, put simply, once the stock is no longer restricted.

Accordingly, corporate management must look very closely at the risks inherent in granting restricted stock to a new high level employee, and, if it is necessary to do, to make sure that a skilled Massachusetts business lawyer is involved as an advisor, negotiator and draftsman.

[The foregoing Article is intended to provide information but not legal advice. Only a lawyer in an attorney-client situation may provide legal advice, upon which you may rely.]

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