Restricted Shares vs. Stock Options: What's the Difference?

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.

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.

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.