Shares and options are securities that belong to different classes, with different characteristics, mechanisms, and structures. But, what are they, how do they differ, how do options work, and how do shares work? Well, both of them are forms of ownership in companies, thereby, each of them is aimed at providing investors with a way to invest in a company and earn returns. To be able to get a clearer picture of the differences between shares and options, this article will help you understand the basics of each of them, as well as how they differ.
Shares and options in business
Shares are the most widely held class of security. This class of securities represents an ownership position in a company and entitles investors to dividends, shares in profits, and voting rights as well. In comparison, options are considered financial instruments that represent the right to acquire shares from the company at a specified price in the future.
From the perspective of private companies, generally, shares are issued to investors such as angel investors, venture capitalists, or private equity firms, who, in turn, provide them with a significant amount of capital. While options are issued to employees, consultants, or advisors that provide some form of service to the company as a part of equity compensation. Hence, in private companies, besides being different in characteristics, both shares and options are different in terms of the purpose they are aimed at.
What are shares and how do shares work?
Shares are basically a unit of equity that represents an ownership position in a company. In general, when shares are issued, the holder will immediately become a shareholder and will be entitled to dividends and earnings. The shareholders in private companies are generally limited in number due to the fact that these companies issue shares to selective investors; however, most of the equity is held by the founders themselves.
In terms of pricing, 409A valuation is used by private companies to determine the fair market value (FMV) of the shares. Unlike public companies, shares of private companies are used within the company itself to incentivize and reward employees, advisors, and investors. As a result, the shares are allocated specifically to these people in order to recognize their service and to show commitment.
Types of shares
Shares can basically be classified into two main types:
- Ordinary shares – These are the most commonly held type of shares, also known as common shares. When ordinary shares are issued, the holder will be entitled to receive voting rights; however, the dividend is not guaranteed. Among all the other shareholders, the holders of ordinary shares typically have the least claim on a company’s assets.
- Preference shares – These are the shares that have a fixed entitlement to dividends but do not have the right to vote. In fact, shareholders of preference shares are prioritized in terms of the distribution of dividends in comparison to shareholders of ordinary shares. Therefore, compared to ordinary shares, preference shares are generally less risky but tend to have a lower rate of return.
What are options, and how do they work?
Options are basically a form of derivative that represents the right, not an obligation, to buy a share at a specified price (known as the strike price) within a predetermined time. There is a vesting period, which is the duration in which the shares must be held by the company till the time the vesting period is completed. Exercise refers to the action of actually buying the shares when the terms of the options and vesting period have been fulfilled.
As a result, there is no instant conversion ownership; hence, the option holder must hold as per the predetermined time and exercise the right according to the terms and conditions of the options. Usually, options are granted as part of an equity compensation plan to incentivize or retain employees. It is essential to note that the strike price of an option is determined on the basis of fair market value at the time of grant.
Types of options
There are two types of options; call and put option. Below is a brief explanation of each of them:
- Call options – A call option gives the right to buy a security at a preset price for an agreed period. Therefore, holders will only exercise their rights to buy a share of the company at the agreed price if they choose to do so, however, before the expiration of the option. The investor will opt for the call option in case they expect a rise in the price of shares.
- Put options – It is the opposite of a call option. Put options give the right to sell a share at an agreed price for an agreed period. If the holder chooses to exercise their right to sell, the put option will expire before the date of expiry. While holders will prefer to hold the put options if they expect a fall in the price of shares.
When is ownership given?
An option is a binding agreement between the holder and the company issuing it. While a vesting period is usually determined at the time of the issuance, options are usually granted to retain key employees and incentivize them to work for the company. When an option is exercised, it immediately gives the right to purchase shares in a private company. As a result, there is no instant transfer of ownership, such as in the case of shares, and thereby the option holder can become a shareholder after a specific period of time.
Shares, on the other hand, are straight equity in a company and thus represent direct ownership. Unlike option holders, shareholders own shares without the need to exercise them. This also means that the way their own value is taxed is different from options on a vesting schedule.
For total diluted ownership, you should also consider if the ownership is in preferred stock or common stock.
Key differences between shares and options
In general, people often get confused between shares and options. However, now that you know the basic concept of shares and options, let us look at the most important and key differences between them. Following are the key differences between shares and options.
Buying and granting
|Buying shares and allocating them to private equity investors are usually done in private companies, and likewise, the holder of shares is entitled to all the rights and duties of a shareholder, including voting rights and dividends. Thus, the holder is given a portion of ownership instantly.||In comparison to shares, companies grant options for the purpose of incentivizing employees or investors, and the option holder does not own an instant share of the company. At the time of the grant, option holders generally get to buy the shares at a specified price after a period of time.|
|Private companies issuing shares usually calculate the fair market value (FMV) of the stocks with the help of 409A valuation. Based on the 409A valuation, the price of the share can be paid according to the current FMV, or in some cases, the shares can be issued at a nominal value, such as $0.01 per share.||At the time of the grant, the strike price is calculated on the basis of the FMV of the company, then after a certain period of time, the holders of options will be entitled to buy the shares at that same price. However, unlike in the case of shares, the holder is not required to pay any amount at the time of grant.|
|Since the shares of private companies are usually allocated upfront to employees, however, if the employee terminates the job before the vesting period, they will be forced to sell the unvested shares back to the company at the price of either nominal or nil value. This is known as reverse vesting, and it is common in many private companies.||Options are generally granted to employees of the company, and later, they can be bought at the strike price on predetermined vesting conditions and within a specified timeframe. It works on a forward vesting process, i.e., the holder can purchase the shares after a particular time period.|
|When a private company issues shares to an individual, usually issued at a nominal value of shares. Thus, the holder will be liable to pay income tax on the difference between the nominal value of the share and the fair market value (FMV) of the share (409A valuation) at the time of the grant.||When an option is granted, there is no tax implication for the buyer. However, when the holder of the option exercises the option, depending on the type of option, they might be liable to pay tax on the difference between the strike price and FMV of stock. Additionally, at the time of sale, the holder will also be charged with capital gains tax; however, the tax rate is different as per the holding period.|
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