Stock options and restricted stock units are methods used to compensate employees with a stake in the actual ownership of the company they work for. Many employers believe such ownership rights motivate employees more because they can, to some extent, increase their own wealth if the company performs well, thereby encouraging them to work harder at their own jobs.
Stock-based compensation is a method of compensating employees with an ownership stake in the company for which they work. Stock-based compensation is common particularly in young, start-up companies that have limited financial resources but potential for significant growth. Employees are paid, in part, with a share of that potential growth rather than exclusively with a wage or salary. Two types of stock-based compensation are stock options and restricted stock units.
Stock options are contracts giving the holder the right to purchase stock at a particular price by a set date. For example, an employee of XYZ Corp. might be compensated with an option to purchase 5,000 shares of the company stock at £6 per share within the next five years. If, in three years, the stock price has appreciated to £45 per share, the employee could exercise her option and purchase those 5,000 shares for £32,500 and sell them for £227,500, making a profit of £195,000.
Restricted Stock Units
Restricted stock units are similar to stock options and gained popularity after accounting changes required employers to expense employee stock options. Restricted stock units are essentially rights to stock that are not entirely transferable until various conditions have been met. These conditions could include certain financial goals of the company. For example, a start-up company could issue restricted stock units conditional on the company achieving a certain level of earnings per share.
One of the most important differences between restricted stock units and stock options is their tax treatment. Stock options are taxed at the time the option is exercised. An employee could be given stock options throughout a 10-year career and not be taxed on them until she actually exercises her right to purchase company stock. Restricted stock units are taxed at the time they vest, meaning when the preconditions are met for their full transfer.