Stock Options vs Equity Differences and Similarities

Stock options vs equity differ in many ways. These two types of investments can be granted to employees in a startup company as a form of the employee compensation plan. It’s a common issue for ambitious startups to want to draw in top talent to advance their company, but they frequently lack the funds to offer top salaries. Because of this, many startups include stock options or equity shares in their compensation packages for employees. This article will explain the differences between stock options and equity using some key criteria like ownership, payment, vesting, and tax treatment. These differences will enable you to make an informed decision on which investment is better for you. But before we start comparing stock options vs equity we would like to briefly explain what they are all about.

Options have a lot of potential value and can give you a chance to profit if the stock price increases. They can also be risky because you might not be able to exercise your option and actually buy shares of the company’s stock if the stock price drops below the option price.

What is equity?

To begin, equity is a type of stock that serves as a source of long-term capital for businesses. Companies issue equity stocks in exchange for capital, which investors purchase at a predetermined price known as the par value.

By doing so, the investors acquire ownership in the issuing company, have a claim to distributions and assets, and have the right to cast a vote on business-related decisions.

Equity stocks are widely recognized to be a long-term capital source for businesses because they have no maturity date, which means they exist for as long as the issuing company does. This makes them an appealing investment option for investors.

Now that we have established an understanding of what equity and stock options are, we can then proceed to the comparison using some key criteria.

Stock options vs equity differences
Stock options vs equity differences

Read more: Differences between shares and stocks

Stock options vs equity differences

The primary distinction between equity and stock options is one of timing. Anyone who purchases equity becomes an instant shareholder and investor in the company. When purchasing these shares, certain rights, such as voting rights and dividends, are frequently included.

While on the other hand, giving someone stock options gives them the right to purchase shares in the future, but they do not become shareholders or have any rights associated with the shares until they actually own the shares.

So far, it appears straightforward but let us critically examine the distinctions between shares and options in the five (5) categories listed below:

  • Company ownership
  • Payment
  • Vesting
  • Tax implications and incentives or benefits
  • Types

Company ownership

Stock options are the promise of ownership of a stake in the company at a fixed point in the future at a fixed price, whereas equity gives the holder immediate ownership of a stake in the company. The only time option holders become shareholders are only after their options have been exercised and converted into equity(shares). We will now explain each company’s ownership below.

Equity company ownership

To be more elaborate, as soon as shares are issued and allocated, the holder acquires equity ownership in the company and becomes a shareholder. This indicates that they are entitled to all shareholder rights associated with the share class, including the right to vote, the right to dividends, and the right to their share of the company’s assets in the event of a winding-up, liquidation, or sale.

As an illustration, Dan is given 1,000 ordinary shares, each of which has one vote and the right to dividends. The company has 100,000 ordinary shares total (including Dan’s 1,000 shares) in its share capital. If dividends are ever paid, Dan will own 1% of the company (1,000/100,000), have 1% of the voting rights, and be eligible to receive 1% of them (few startups pay dividends in the early stages).

Stock options company ownership

Stock options alone do not grant company shares or any shareholder rights, in contrast to equity. As an alternative, the option holder is entitled to convert their option into shares at a later time and at a pre-determined price (the strike price). Giving employees options rather than equity shares has many advantages, one of which is the ability to regulate and place restrictions on when options are exercised.

Options are a great way to reward team members in early-stage companies without increasing salaries or ceding control. After all, until their options are exercised, the option holder will not have voting privileges in the company. Stock options are the carrot that keeps key employees on board because they can make up for a low salary by promising future shares.

An illustration would be Alice receiving 1,000 options with a three-year vesting period. Alice has the option to exercise her options and convert them into 1,000 common shares with a dividend right and one vote each after the vesting period has ended. Alice chooses to exercise her option after three years and joins the company as a shareholder.

Payment

Another important distinction between stock options and equity is how they are purchased. This distinction affects both the individual receiving equity and the company granting it. To avoid problems in the future, it is critical to carefully consider which form of equity compensation to use. The sections that follow explain when and how employees pay for equity shares versus stock options.

Stock options payment

When options are granted or vested, no money exchanges hands. Instead, when an option holder chooses to exercise their options and convert them into shares, they pay the strike price. The strike price is typically a discount from the fair market value at the time the options were granted. The fair market value is determined by the price paid per share in the most recent funding round.

In some cases, the strike price may be lower than the market value or even the nominal value. There may be tax implications in these instances. To exercise their options, the option holder must first pay the strike price.

For example, suppose John is given 1,000 options with a strike price of $20 per option. When John wants to exercise the options after three years, he must pay the company a total of $20,000 (1,000*$20).

Equity payment

When equity shares are granted as a condition of employment, they are frequently issued at nominal value, such as $0.01 per share or more. In the event that shares are issued at nominal value, the employee will pay almost nothing for their shares and won’t have to do so again.

For example, at a nominal value of $0.01, Dan receives 1,000 shares of common stock. Dan will purchase those shares from the company for $10 (1,000*$0.01) and become the owner of them after allotment.

In another example, David receives 1,000 common equity shares at a cost of $10 per share (including $0.01 in nominal value). David will purchase the shares from the company for $10,000 (1,000*$10) and become the owner of them upon allotment.

Related: What is Negative Equity?

Vesting

The term “vesting” describes the time frame during which equity shares and options are “earned.” Only after this time period has elapsed does the holder acquire full ownership of the equity (shares or options). Typically, equity shares vest backward while stock options vest forwards. This phenomenon will be explained below.

Equity shares reverse or backward vesting

A shareholder is initially issued and given a certain number of equity shares. The unvested shares must be sold back to the company, typically for little to nothing, if the shareholder leaves the business before the end of the vesting period.

Startup founders frequently have a reverse vesting schedule for their shares. It helps prevent a scenario in which a significant shareholder abruptly leaves the business and takes a sizable portion of equity with them. This might render the business uninvestable.

For instance, Joe receives 1,000 ordinary shares that vest retroactively after four years. If Joe decides to leave the company after a year he’ll be left with 750 unvested equity shares. Then the 750 unvested shares may be repurchased by the company because a reverse vesting condition was in effect.

Stock options forward vesting

This means that stock options are acquired gradually over time, typically over a three- to four-year period. The vesting schedule may also be constructed so that the employee must reach specific objectives in order to acquire his or her options.

The primary goal of establishing a vesting schedule for stock options is to motivate the employee. The more options that vest and become exercisable the longer an employee stays with the company.

For instance, Jane receives 1,000 options that will vest over four years. She leaves the company after a year, with only 250 of her outstanding 750 options vested.  Jane might be able to exercise her vested options at this time, depending on the terms of the option grant. Companies frequently impose restrictions, such as the requirement that options can only be converted once the entire allocation has vested or after the option holder has left the company for a period of 30 to 90 days.

Tax implications and benefits

Although this may appear complicated, the fundamental ideas behind the tax strategies are actually quite simple. We’ve attempted to simplify it to taxed or untaxed equity shares or stock options which will be explained below.

Taxed equity shares

In general, both the employee and the employer will immediately pay taxes as a result of issuing and allocating shares to a person at a discount.

IRS either uses the price paid per share by investors in the most recent funding round or the earnings per share based on the company’s trading history to determine the market value of the shares. The difference between the market value and the nominal price paid by the shareholder is taxed. This differential is taxable as employment income because it constitutes income.

Ben, for example, is given 1,000 Ordinary Shares and asked to pay just $0.01 per share in nominal value. But since the IRS estimates that each share is worth $20 (based on recent investment activity or trading activity), the $19.99 differential counts as income and is subject to income tax as well as potential National Insurance contributions.

Untaxed equity shares

In untaxed equity shares, one might think that the taxman says they want income tax on the market value of the shares, but my startup hasn’t raised money and hasn’t made any money, so it has no market value. Therefore, can my startup simply give shares to someone at face value without incurring tax liability?

That’s a valid point, indeed. Because the shares have no value when they are allocated, early-stage startups that are pre-funding and pre-revenue can give shares to someone at a nominal value without incurring any tax. However, since individual circumstances can differ, please get tax advice before making a decision like this.

Taxed stock options

When stock options are granted or vested, neither the company nor the option holder pays any taxes. However, when the options are exercised, the option holder will be responsible for paying income tax and NICs on the difference between the strike price and the shares’ then-current market value. The employee must also pay capital gains tax on the profit when they sell the shares (CGT).

For instance, Alice receives 1,000 options with a $20 per option strike price. After completing the requirements of her option grant three years later, Alice exercises her options and pays the business $20,000 (1,000$20). Due to the company’s recent success, the shares’ actual market value has increased to $100, making Alice the owner of $100,000 worth of shares (1,000$100). The $80,000 price difference between what she paid and the actual market value is subject to income tax and national insurance contributions (NICs). Alice will also pay CGT of up to 20% when she sells her shares for $100,000 in total.

Untaxed stock options

As you might expect, the actual market value of the shares at the time of exercise could be very high, which would result in a significant tax burden. Given the potential tax repercussions, how can you ensure that your employees’ options remain appealing?

To address this, the business and the IRS decide on a market value at the time the options are granted. If the shares are exercised for at least the market value they had when the options were granted, the option holder does not have to pay income tax or NICs when the options are exercised. When the shares are sold, capital gains tax is also capped at 10%. The company that granted the stock options also benefits because won’t pay any tax from the already allocated options.

Types

Another essential criterium in differentiating between stock options and equity is their types which will be briefly explained below.

Stock options type

  • Call option
  • Put option

Stock options types are available for purchase and sale by investors in the hopes of making a profit, but the stocks do not demonstrate ownership or equity. This implies that purchasing listed options will not grant you equity in the business. Options are merely tradeable derivative contracts that do not give their holders ownership of the underlying asset. They are crucial for protecting against market turbulence.

Call option

A call option grants you the right to purchase shares of stock at a predetermined price within a specified time frame. The fixed price, as with put options, is known as the strike price, and the date after which your options expire is known as the expiration date. It means that you are permitted to purchase the company’s stock at a fixed price within the agreed-upon timeframe; market fluctuations have no bearing on it.

For example, let’s say Dan bought call options to purchase 500 shares of stock for $20 per share within four months at a premium of $1 per share. In this case, $20 is the strike price. Dan can now buy the stocks at $20 if the stock price rises to $30 per share in the following four months.

Put option

A put option grants you the right to sell shares of stock at a predetermined price before a predetermined date known as strike price and expiration date just like that of the call option. This type of option is useful for hedging against a future drop in the underlying security price.

For instance, if you own shares of a company and believe that the market value of those shares may decline before a certain date, you can purchase options that will cover those shares and, regardless of what occurs, the most you could lose is the price you paid for the options to be used as a hedge and any related fees. In doing so, it lowers the possibility of losing the entire underlying security.

Equity type

  • Authorized stock
  • Issued stock
  • Subscribed stocks
  • Right share
  • Bonus shares
  • Sweat equity shares
Authorized stock

A company’s authorized stock is the maximum number of common and preferred shares it can issue. This maximum number is usually specified in the charter of the issuing company or can be legally determined by the rules and regulations governing the issuance of shares by companies as issued by the country in which the company is incorporated.

Issued stock

The term “issued stock” refers to all of the authorized shares that the issuing company has made available for investor purchase. It is the total amount of all issued and treasury shares. All issued shares that are still in circulation are those that shareholders have acquired and are still holding.

Subscribed stocks

Subscribed stocks are those that banks and institutional investors have agreed to buy ahead of the issuing company’s initial public offering (IPO). These financial institutions and institutional investors are known as subscribers.

Right share

A right share is a share that a company offers to its existing shareholders for purchase rather than selling to new investors in order to avoid stock dilution. The price of shares issued during a right share is typically lower than the stock’s current market price.

Bonus shares

The term “bonus shares” refers to shares that the issuing company grants to its existing shareholders in place of cash dividend payments; since the shareholders are not required to pay for these additional shares, it is said that they are being given for free. According to their current share count or the equivalent of the dividend they were supposed to receive, each shareholder will typically receive bonus shares based on how many shares they currently hold.

Sweat equity shares

Employees who have demonstrated exceptional dedication and excellent performance in their various duties, including using their skills readily and granting intellectual property rights, among other things, are given shares known as sweat equity shares. It is given in lieu of cash bonuses or overtime pay to recognize employees’ time, effort, and dedication that has helped the business expand or run smoothly.

Read also: What are Authorized shares?

Stock options vs equity which is better?

People are interested in learning what kind of offering opportunity would have the best returns in a reasonable amount of time with the least amount of risk. Stock option and equity investing are two common offering opportunities; each has pros and cons, unique returns, and unique risks.

It is wise to consider all relevant factors, including tax implications, risk, vesting, and a host of other elements, before making a choice. Equity and stock options are both beneficial, but one may be more advantageous for you than the other.

Summary of the key differences between equity and stock options

Equity sharesStock options
Take immediate ownership of shares.Possess the option to purchase shares at a future date or at a predetermined price.
Voting rights, dividends, and any other rights pertaining to the class are typically included.The vesting schedule may serve as a motivational tool for employees.
Usually given to co-founders and investors.Usually given to employees
Equity shares are normally taxed.They are not taxed until they are exercised by the owner.
The key differences between equity and stock options

Similarities of equity and stock options

  • Similar to regular equities, options are listed and traded on national markets that are under SEC regulation.
  • Also, similar to equity buy and sell orders, option orders are executed through brokers using bids to buy and offers to sell.
  • Through the exchanges where they trade, buyers and sellers of options and stocks can monitor performance and follow transactions.

Conclusion on Equity vs Stock options

On a whole, it is important to know the difference between stock options and equity in financial management, because it helps you to choose how to maximize your money by investing wisely, in what suits you. We now have an understanding of how equity differs from stock options in terms of ownership of the company, payment, vesting, tax, and types.

Many startups always contemplate offering employees stock options or equity shares as part of compensation or payment structures. With this article, they can now choose which one better suits them as both equity and stock options have advantages and disadvantages.

Related: Diluted and unlisted shares

A video explaining stock options vs equity in startup businesses.
Last Updated on August 27, 2022 by Nansel Nanzip Bongdap