Today’s topic is simply – What’s better for you – Stock Options or Restricted Stock Awards? The longer title here should be something like what is better for your personal situation? Receiving Restricted Stock Awards or being awarded Non-Qualified Stock Options. But that is way too long. I’m sure an editor would say this should be titled “What’s best” but I still hear some grade school teachers yelling at me explaining this is not a best situation as there are only two choices. Finally, let’s get to it.
I want to start by talking briefly of the trend right now with Equity Compensation. Oh, before I do that, let me mention that not every employer allows you to choose between receiving your Equity Compensation as either a Non-Qualified Stock Option (Stock Option) or Restricted Stock Award (Restricted Stock). However, there are plenty that do allow you to make a choice. Some of them are even progressive enough to allow you to choose between either or do a combination. That seems like a pretty sweet deal to me.
Back on track here. The trend in the past handful of years has changed with the issues of Stock Options vs Restricted Stock. A dozen years ago nearly ¾ of Equity Compensation was awarded as a Stock Option. These make sense because there is no risk with issuing and receiving Stock Options. If they do not increase in value over the exercise period you are not out anything. However, the gap between the issuance of Stock Options and Restricted Stock started getting narrower in the last decade. Roughly 5 years ago the trend flip. Now more shares of Restricted Stock are awarded than Stock Options. The last data I have is from 2017, so it is kind of old. At that point, Restricted Stock represented about 60% of Equity Compensation awards.
There’s one overarching reason behind this shift. Yeah, Stock Options were all the madness before the dot com bubble burst. You know the old jokes that if you put a .com behind a company’s name in the late 90s it would skyrocket in value. Sadly, there is some truth to that. However, many employees and employers realized a hard lesson. Stock Options only have value IF the price of the options goes up.
Let me say that one more time. Stock Options only have value IF they go up in value. That is the downside of the positive of there being no risk in accepting a Non-Qualified Stock Option. You’ve heard me talk many times there is no reason to NOT accept a Stock Option if your employer offers it to you. Unless the Option goes up, there is no reason to exercise and buy the stock. It is at the point you exercise where you incur things like taxes as you now have bought and own the stock.
Restricted Stock Awards are the opposite. Once they vest you have value with those shares. Actually, you have value before they vest, but that is a more detailed explanation. Yes, the shares may go up or down in value, but there is still a value to them. So, you get some money once your Restricted Stock vests unlike Non-Qualified Stock Options that may never increase in value so no reason to exercise and become a shareholder of.
I’m not going to speculate who drove this change, just know it is not a bad one. You have less control with Restricted Stock when it comes to things like vesting and taxes, but again, there is some intrinsic value that exists with them that simply does not exist for Stock Options.
With that bit of background, let’s look at the positives and negatives with each of these two choices. How about we start with Non-Qualified Stock Options.
The first positive is one I mentioned already. There is no risk in accepting Stock Options. Accepting Stock Options does not mean you have to exercise them. It simply means you have the option to exercise them at some point during the exercise period which is often ten years in length. If the value of the stock goes below the exercise price when it was awarded to you, well, you are out nothing because there is no reason to exercise them. However, if they go up in value and are now in-the-money, well, it makes sense to exercise them and take control.
Another positive is there is no performance connection to whether they vest. At least not that I’ve seen. While some awards require certain goals to be hit, like a sales goal or even being at the company a certain amount of time, Stock Options just have a time period when you can decide to vest them through exercising the options. You can say the performance is there because the stock price needs to go up in value, but odds are that is not within your sole control.
The final positive I want to mention comes to taxes. Stock Options are taxed at Ordinary Income when you exercise them. This isn’t as positive as if it were at lower capital gains rates, but that’s not the point. With Non-Qualified Stock Options you have leeway when you exercise them which helps control your tax bill. Say for example, you are in year 9 of your exercise window for Stock Options. The value of the stock is near an all-time high. You also just found out you are going to be in a higher tax bracket the next year, maybe due to a raise or even just a change in tax rates. Well, with Stock Options you could go ahead and exercise those options before the ten-year window arrives and pay a lower tax bill. I mean, unless you like tipping Uncle Sam.
Now to a few negatives with Stock Options. First one is something I mentioned earlier. There is no intrinsic value with Stock Options. At least until you exercise and then own them. I won’t go over this point again since I covered it earlier.
I am going to quickly go through some more negatives here. There are no dividends. Hard to receive dividends on stock you don’t own or control. And since you don’t own them, there are no voting rights with Stock Options either.
Final comment when it comes to Non-Qualified Stock Options. And this one is going to be a broken record of hopping on the old soapbox. 11% of in-the-money options are allowed to expire unexercised every year. Do NOT be part of this statistic of leaving free money on the table. It does nothing but harm your financial future.
How about we jump to some positives and negatives with Restricted Stock Awards now. We’re starting positive again. And again, it is something I mentioned earlier. Restricted Stock has intrinsic value when you receive it. Yeah, the price will move up or down or both from what the price was when awarded, but odds are it won’t go to zero, so there will always be some value. So, unlike Stock Options which don’t have a value until you exercise them, you always have some intrinsic value with Restricted Stock.
The big difference of Restricted Stock Awards and Restricted Stock Units is you basically own Restricted Stock when it is awarded to you. Technically, the employer can pull it back if you do not fulfill the vesting requirements, but because you own it there are some other positives.
The two main positives are the opposite of a couple of negatives with Stock Options. You get dividends and are allowed certain shareholder voting rights with Restricted Stock.
The final positive is related to taxes. Yes, a positive is actually related to taxes. Hard to believe. Restricted Stock has the old 83b election associated with it. I’ve covered this other times so I won’t go into detail. The short version is you have 30 days from receipt of the Restricted Stock to decide if you want to accelerate the recognition of taxes on this stock. This may make sense if you firmly believe the stock will be much higher down the road and/or your tax rate will be higher. Again, talk to your CFP® who caters to Equity Compensation like I do on this topic and it would make sense to pull in your CPA too.
We do have to hit some negatives. The first is the tax rate is also at the higher ordinary income rate. Wish it was the lower one of capital gains, at least potentially lower rate. However, when the shares do vest they are recognized as though you earned that value. This is why people consider Restricted Stock Awards and Restricted Stock Units to be cash bonuses. The only other negative to mention is just a reminder that although you control Restricted Stock, you really do not fully own it. The shares still have to vest. It may seem as though you own them due to dividends, voting and other things, but in reality, they are most likely sitting in escrow. So, if you don’t fulfill the vesting requirements, like you leave early, the employer will simply pull them back.
So, which one is better? Again, depends on your personal situation. I love the fact the Stock Options have no risk, but I also like how you get immediate intrinsic value with the awarding of Restricted Stock Awards. Stock Options make a lot of sense if you are planning to be at your company for a long time, while Restricted Stock usually has a shorter vesting period connected with them. Both have some flexibility with recognition of taxes too. I guess the tie-breaker for me is there really is nothing to think about with Restricted Stock Awards. What I mean is that if you receive them and totally forget this happened, odds are high they will vest and fully belong to you. Non-Qualified Stock Options require you to make an active decision to actually exercise them. This is where 11% of the in-the-money fail. I guess you could say Restricted Stock Awards win out because they are more dummy proof. Or is it dummier proof? We never covered in grade school English.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.