Restricted Shares vs. Stock Options: An Overview
Restricted shares and stock options are both forms of equity compensation, but each comes with some conditions. Restricted shares can either be restricted stock units or restricted stock awards. Both involve vesting requirements. Stock options give an employee the right to buy a certain number of shares at an exercise price in the future. Like restricted shares, stock options often have vesting requirements. The employee may get a windfall if and when the company’s stock price exceeds the exercise price and they exercise the options.
Key Takeaways
- Restricted shares and stock options are both forms of equity compensation that are awarded to employees.
- Restricted shares are issued as restricted stock units and restricted stock awards.
- Restricted stock awards represent actual ownership of stock and come with conditions on the timing of their sale.
- Stock options represent the right to buy a certain number of shares at a certain price in the future
- An employee benefits from stock options when they buy the stock at the exercise price and then sell it at a higher price.
Restricted Shares
Restricted shares are unregistered, non-transferable shares issued to a company’s employees. They incentivize employees to help companies attain success. They are common in established companies that want to motivate people with an equity stake. Their sale is usually restricted by a vesting schedule. Because the value of restricted stock relies on the company’s stock price, it can encourage employees to perform better.
An employee receives restricted shares on the condition that they will continue to work at the company for a certain number of years or until a company milestone is met. This might be an earnings goal or another financial target. What’s more, an executive who leaves the company fails, to meet performance goals, or runs afoul of Securities and Exchange Commission (SEC) trading restrictions may have to forfeit their restricted stock.
Restricted shares are often granted in stages, each having a vesting date or milestone attached. This gives employees rights to company assets over time. Once vested, restricted shares are assigned a fair market value (FMV).
Restricted shares may also be restricted by a double-trigger provision. That means that an employee’s shares become unrestricted if the company is acquired by another and the employee is fired in the restructuring that follows. Insiders are often awarded restricted shares after a merger or other major corporate event. The restrictions are intended to deter premature selling that might adversely affect the company.
Restricted Stock Units and Restricted Stock Awards
There are two variations of restricted shares; restricted stock units (RSUs) and restricted stock awards. RSUs represent an employer’s promise to grant an employee a specific number of shares at a specific future date. They don’t come with voting rights. They must be exercised to be converted to actual shares. In certain circumstances, they may be redeemable for cash. Once converted to actual shares, they confer shareholder rights (including voting rights) upon the employee.
Employees who receive restricted stock awards own the stock outright when it’s awarded. Owners have all shareholder rights. The owner may receive dividends and vote at the annual meeting. However, the company may reserve the right to buy back unvested shares if the employee leaves the company.
Stock Options
Stock options represent a right to buy (or sell) shares at a specific price (the exercise price) at some future date. They do not involve a transfer of ownership. An employee may profit by the difference between the exercise price and the actual market price. They’re often granted by startup companies to motivate employees to help get the company off the ground.
Stock options are normally restricted by a market standoff provision, which restricts the sale of shares for a certain time after an initial public offering (IPO) to stabilize the market price of the stock. Stock options provided as compensation by a public company often have a vesting schedule. This prevents people from leaving a company after only a short time with shares of company stock that could become valuable.
A stock option involves a specific transaction date, an exercise (or strike) price, and the number of underlying shares involved. One stock option contract represents 100 shares of stock. The value of a stock option depends on the difference between the exercise price and the market price of the underlying stock.
Key Differences
It’s important to familiarize yourself with the differences between restricted shares and stock options because the features of each can require different planning for the benefit you may receive.
| Restricted Shares | Stock Options | |
|---|---|---|
| Issuance | Granted | Purchased |
| Value | Fair market value | Difference between the exercise price and market value |
| Variations | Restricted stock units and restricted stock awards | Non-qualified stock options and incentive stock options |
| At Vesting | Shares typically deposited into a brokerage account (no action needed) | Employee must exercise option and decide whether to hold or sell |
| Risks | Less risky because employee receives stock with FMV | More risky because value may be zero if market price is equal to or less than the exercise price |
| Taxation | Gains taxed as ordinary income in the year they vest (except with 83(b) election) | NSO gains taxed as ordinary income whether held or sold while ISOs may be taxed as ordinary income, long-term capital gains, or according to the alternative minimum tax |
What Does It Mean When Shares Are Restricted?
It means that they cannot be sold until the conditions of restriction are met. For instance, restricted shares given as a form of compensation usually are accompanied by a vesting schedule that establishes a period (or periods) of time that must pass before shares can be sold. Additionally, specific financial milestones may need to be met before employees may sell their shares.
When Should You Exercise Stock Options?
Generally speaking, if you have an option to buy, you’d exercise stock options within the time specified by the option contract and once the current market price rises above the strike price. That way, you can profit by selling the shares at a higher price than what you bought them for.
What Is Better, Stock Options or Restricted Stock?
It depends on how you view both forms of compensation. Restricted shares can be considered less of an effort to deal with because, typically, once vested, they’re automatically deposited in a brokerage account on your behalf by your employer. Plus, restricted shares represent actual shares given to you. You don’t have to buy them. Stock options involve more effort because you must exercise them and buy the underlying shares. There can be different tax implications, as well.
The Bottom Line
Some public companies provide their employees with stock as a form of compensation. This is usually in addition to your salary to help motivate you to be part of the company’s success. This type of compensation can come as restricted shares or stock options. Understanding how they work and the implications involved can save you a lot of money in the long run.