Restricted Shares vs. Stock Options: Definitions, Differences, and More

Restricted shares and stock options are two ways in which companies can reward their employees and investors who help the firm grow. However, they're not the same thing and differ in certain aspects. Both give a chance to own part of a company, but the rules, timing, and benefits vary. In this article, we explain restricted shares and stock options, how they work, and how they differ so one can make better decisions about them.

Restricted shares are stock given by a company to employees or investors with specific rules attached. These rules often limit how or when the shares can be sold. The restrictions usually aim to keep employees with the company longer or ensure they meet specific goals before fully owning the shares.

Companies often give restricted shares as part of an employee's pay or as a bonus. These shares are not wholly owned at first. Instead, they come with a vesting schedule, which means employees earn full ownership over time or after meeting certain conditions.

The vesting period is when an employee must wait before fully owning restricted shares. For example, an employee might get 1,000 shares but can only own 250 annually for four years. During this time, the employee may not sell or transfer the shares. After the vesting period ends, the employee has full rights to the shares.

Restricted shares give employees a way to own part of the company. The shares can become more valuable over time if the company does well. Unlike stock options, employees don't have to buy the shares, which makes restricted shares a lower-risk reward. They also motivate employees to stay with the company longer.

Stock options are a company's offer to employees or investors to buy shares at a set price, called the grant price, after a specific time. These options mean the person needs to wait to own shares; they give the right to buy shares later, often at a lower price than the market value.

There are two main types of stock options: Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs). NSOs are offered to employees and sometimes non-employees and come with regular tax rules. ISOs are only for employees and provide unique tax benefits if certain conditions are met. Each type has different rules about taxes and ownership.

When a company grants stock options, the grant price is set at the price at which the shares can be bought later. After a waiting period, known as vesting, a person can purchase the shares at the grant price. If the market price exceeds the grant price, the person can sell the shares for a profit.

Stock options give employees a chance to benefit from the company's success. If the company's stock price increases, employees can earn more by exercising and selling their options. This potential profit rewards and motivates employees to help the company grow and perform well. Stock options also let employees share in the company's long-term success.

Restricted shares immediately give the employee or investor ownership, even if restrictions apply. On the other hand, stock options only provide the right to buy shares later. In short, with restricted shares, you get to own your stock. With stock options, ownership happens only after exercising the option.

Both restricted shares and stock options have vesting schedules but work differently. Limited shares are owned immediately, but one cannot sell them until the vesting terms (like the vesting period) are met. Stock options require the individual to wait until the vesting period ends before they can be exercised to purchase shares. The timelines and conditions often vary between the two.

The tax rules for restricted shares and stock options are different. Restricted shares are taxed as ordinary income when they vest, based on their value at that time. Stock options, especially ISOs, can qualify for capital gains tax treatment if conditions are met, potentially reducing the tax burden compared to restricted shares.

Restricted shares have a guaranteed value since they are owned from the start, even if restrictions apply. Stock options, however, depend on the market price being higher than the grant price to have value. This makes restricted shares less risky but with limited upside, while stock options carry more risk but higher potential rewards if the company performs well.

Choosing between restricted shares and stock options depends on goals and risk tolerance. Restricted shares offer you immediate ownership and lower risk as an employee (since they hold value even if the company's stock price does not rise). A better choice for guaranteed rewards and stability. On the other hand, stock options provide higher returns if the company's stock price goes up due to trends or growth, but they come with more risk and depend on market performance. Both have their potential rewards. The best decision depends on personal situations.