While it’s common knowledge that stocks are a popular way for employees to benefit from the success of a business, there are two types of stock ownership available: one is restricted shares and the other is stock options. These two concepts can get a little confusing as restricted stock and stock options are both ways to incentivize employees. But there’s a big difference between these two equity compensation plans, how they work, and which one might be right for your company.
Restricted Shares – What are They?
Restricted shares are stocks that have restrictions placed on them by the company but are used to incentivize employees. So, when you purchase restricted stock, you are purchasing ownership in a company. However, your ability to sell the stock does not begin until the mandatory restrictions are met. This means that if you purchase 100 shares of restricted stock, it is unlikely that you will be able to sell those shares as there may be additional conditions. Moreover, the type of restriction imposed will depend on the specific company and its policies.
To clarify ambiguities, it must be kept in mind that restricted stock is a type of equity, and it comes in two flavours: incentive stock options (ISOs) and nonqualified stock options (NSOs). Furthermore, restricted shares are awarded to an employee as part of an employment package, but they don’t take effect until restrictions imposed on them by the issuing company lapse. For example, if you get restricted shares that vest over time or only under certain conditions, your employer doesn’t have to report those shares until the restrictions lapse.
What are Stock Options?
Stock options are a type of employee stock option issued by corporations as an incentive to employees. This is the most common form of equity compensation for executives and key employees. Options are attractive to prospective employees because they have the potential to increase their wealth, even though they are not guaranteed future income.
Corporations use stock options as a way to attract more qualified candidates since it is one more financial benefit that can be used in salary negotiations. Other than that, stock options are an instrument that gives the holder the right, but not the obligation, to buy or sell shares of stock at a fixed price. However, the availability of stock option grants is an important feature in many compensation packages for elite employees.
Moreover, an employee may be granted stock options if he or she has demonstrated outstanding performance over time. However, stock options are available to all types of businesses, from startups to well-established companies with public stock traded on exchanges.
Restricted Shares vs. Stock Options
As mentioned above, the two most common ways for companies to issue equity in the form of stock to their employees are restricted shares and stock options. Restricted shares are those which are issued at a set price and are usually determined by the company’s board of directors.
Stock options, on the other hand, come with no guarantee that they could be worth anything when they vest. Instead, options give recipients the right to buy shares at a certain price over some time (usually three or four years).
On the surface, restricted shares and stock options can appear very similar, as they both give employees ownership in the company they work for; however, there are some differences between them that businesses should be aware of before deciding which option to offer their employees.
These two common forms of equity compensation are both used to retain and reward employees. However, each has downsides and advantages that make them better for different situations. The main difference between restricted stock (RSUs) and stock options (SOs) is that RSUs vest over time if the recipient remains employed, while SOs typically vest immediately. This means that RSUs offer a potential upside only if the employees remain at their company, while SOs can provide an immediate benefit even if they leave before the restrictions are met.
In general, the tax consequences of these two forms of equity compensation are similar. As both types of grants give recipients a future interest in company shares that they can sell after the vesting period ends. However, there is one major difference: with restricted shares, you pay income tax on them as ordinary income when you receive the shares; with stock options, you do not pay any taxes until you sell those options.
Most companies prefer to offer restricted stock to employees rather than stock options because restricted shares are issued at a set price, and therefore cannot be traded on the open market. In addition, the company taking advantage of this type of equity compensation must withhold taxes from their employees until they vest, which can effectively reduce their net pay.
This might seem like a disadvantage for employees, but some benefits make it a better choice for both parties. Stock options are one of the other great ways to attract talent. As they also provide the employee with enough motivation to work hard and help grow the company. However, stock option plans come with tax implications that can be confusing for first-time entrepreneurs.
The first thing you need to know about stock options is that they’re not free money. Companies will often try to sell them as such by talking about how little it costs for them on the front end, but they fail to mention all the accounting headaches down the road.
Although stock options are commonly used by many companies, the accounting treatment for stock-based compensation has been a source of confusion for many.
But it is pretty straightforward because when you issue an option, it adds additional value to the equity account on your balance sheet, and lowers the amount of expense you need to record in the current period for employee compensation. And when they exercise their options, it eventually increases the amount of stockholders’ equity and reduces your cash balance by the dollar value of their options multiplied by the number of shares acquired with those options.
When to Choose Restricted Shares & Stock Options?
Selling restricted shares is an excellent choice for startups that want to attract new investors. This gives the holder a set number of shares at a set price, and it can be traded on the open market just like common stock.
Moreover, restricted share grants come with some strings attached: they can’t be sold until a certain date, and they must remain under lock and key until that time. These restrictions are important for startups because they protect them from having their equity bought out by early employees before they’ve had time to grow.
Stock options are also a great way for startups to bring in new revenue and incentivize their team. But when is the best time to start using stock options?
Stock options can be a powerful tool for a startup, but many people don’t use them because they aren’t sure when to employ them. There are two main times that companies should consider offering stock options: during the seed round of funding and the Series of financing.
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A: Stock options are better for startups or companies that are in an early stage, whereas restricted shares are better at a mature stage.
A: The value and cost of RSU are much higher than the stock options, which is why companies prefer RSU’s.
A: Yes, you should sell your RSU’s as soon as they vest.