Option grants and restricted stock awards are the two most commonly used forms of equity compensation in emerging businesses.
Stock options are contractual rights to purchase shares of a company's stock at a specified price during a specified term. Options are commonly used as incentive compensation in both large and small businesses. They are typically granted with an exercise price equal to the fair market value of the underlying security (almost always common stock) on the date of grant. Therefore, the option holder benefits from any increase in the value of the underlying security after the date of grant.
There are two broad categories of compensatory options, incentive stock options and non-qualified stock options, a distinction based purely on tax treatment. The grant of a stock option, whether incentive or non-qualified, is not a taxable event. Incentive stock options and non-qualified options differ from a taxation standpoint when they are exercised.
The exercise of a non-qualified stock option is a taxable event. The spread, the difference between the exercise price of the stock option and the fair market value of the underlying security on the date of exercise, is immediately recognized as ordinary income. The exercise of an incentive stock option, however, is not a taxable event. Rather, the optionee acquires the shares at a tax basis equal to the exercise price. No income is recognized until the underlying security is sold. Moreover, if the optionee holds the underlying security for at least one year after exercise, any realized gain in the security (i.e., the difference between the exercise price and the price per share received by the optionee upon the sale) will be taxed as long-term capital gains under current tax laws.
A restricted stock award is a grant of actual shares of equity securities (again, almost always common stock). However, the recipient of restricted stock does not own the securities outright; the recipient takes them subject to the company's right to repurchase the securities in the event of recipient leaves the company. The recipient takes outright ownership of the securities over time in accordance with a vesting schedule set forth in the terms of the grant (for a discussion of vesting, see below).
The default taxation of restricted stock is that shares are recognized as ordinary income upon vesting. With respect to each installment of vesting, the amount recognized as income is the fair market value of the vesting shares on the vesting date. The disposition of the securities after vesting is also subject to taxation for any appreciation in value after the vesting date. Recipients of restricted stock are, however, permitted to make an election, commonly referred to as an "83(b) election" which permits the recipient to recognize the entire award as ordinary income on the date of grant, with the result that the restricted stock will not be subject to any further taxation until it is disposed (at which point it is very likely that the recipient will get the benefit of long-term capital gains treatment on any appreciation in value from the date of grant).
Whether or not a Section 83(b) election will be tax-advantageous depends on a number of factors. The most important factor is the fair market value on the date of grant. Generally, the earlier the stage of the company, the more likely it is that a Section 83(b) election will be advantageous because the fair value of the securities will likely be very low.
Making a Section 83(b) election is not without risk. Most importantly, in the even that the restricted stock becomes subject to a repurchase by the company (usually as the result of the recipient leaving the company), or the company performs poorly or fails, the recipient will have recognized as income and paid taxes with respect to compensation for which the recipient ultimately receives no benefit.
Stock options and restricted stock awards are almost always subject to vesting. When an option "vests" with respect to a portion of the shares subject to the option, it means the holder may exercise the option with respect to those shares. When restricted stock "vests", it means the vested portion of the stock is no longer subject to the company's right of repurchase under the terms of the award.
Vesting schedules can differ widely between companies. The vesting schedule might contemplate straight-line vesting over four years (i.e., the option vests with respect to 1/48 of the shares per month for 48 months) or a one-year cliff followed by straight-line vesting for three years (i.e., the option vests with respect to ¼ of the shares after one year and 1/48 of the shares per month during the three-year period that follows). Vesting can be contingent upon the achievement of performance targets, and vesting is often accelerated with respect to all or a portion of the unvested shares upon a liquidation event (which often includes a change of control of the company).
Whether a company grants stock options or restricted stock to its employees can depend on the growth stage of the company and the type of incentive structure the company wishes to create. While the primary purpose of both options and restricted stock is to provide incentive to employees by tying a portion of their compensation to the growth in value of the company, the incentive structure of options versus that of restricted stock differs slightly. The only way to recognize any value from an option grant (assuming the exercise price is the fair market value of the underlying security on the date of grant) is for the fair market value of the underlying security to increase after the date of grant. Restricted stock will retain some value even if the fair market value of the stock declines. Therefore, options can be a somewhat more powerful incentive to grow the company.
In the case of a restricted stock award structured as a purchase by the recipient at fair market value, the recipient will only recognize value in the event of an increase in the fair market value of the security. Moreover, because in this case the recipient is financially invested in the company, it is possible for the incentive to be even more powerful than with options, because the recipient's net worth actually declines along with the value of the company in a way far more immediate and ascertainable than is the case with options. Such a structure is generally better suited to high-level executives because they are more likely to have the resources to purchase the securities, their impact on the success of the company is likely to be more direct, and the fact that their net worth is tied directly to the company is more likely to ensure a long-term commitment to the company's future than might be the case with stock options.
There are a number of other reasons why a company might opt for one form of equity compensation over another, including accounting impact and tax considerations.