There are many kinds of shares out there used in offering employees with equity compensation. But do you wonder what the best kind of shares are for investors and employees in a company? Well, there are many kinds of shares in the market and each has their own benefits.
Preferred Stock vs Common Stock: Understanding the Difference
Out of the many kinds of shares in the market, there are two main kinds that you might have already heard of: common and preferred stock. And there are huge differences between them. Let us begin by talking about preferred stock.
Compared to common stock, preferred stock usually have no voting rights. This means that when the company has to make any big decisions in the board meeting, those holding preferred stock will not have any vote in the matter. But preferred stocks do offer guaranteed dividends just like bonds.
The dividend calculated for the preferred stock is done as the dollar amount of a dividend divided by the price of the stock. It is normally based on the par value before the preferred stock is offered and calculated as a percentage of the current market price after it begins trading. And this is the main difference it has from common stock which has variable dividends declared by the board of directors and never guaranteed.
As a matter of fact, there are a lot of companies out there that do not pay dividends to the common stock at all. Just like bonds, preferred shares also have a par value affected by interest rates. The moment the interest rates rise, the value of the preferred stock declines and vice-versa. However, with common stock, the value of the shares is regulated by the supply of market participants.
Preferred stock also gets priority over common stock. This means that in case the company misses a dividend payment for the shareholders in the company, the ones who own the preferred stock are paid first before all the other common shareholders are paid off.
During liquidation, the preferred stockholders are the ones who have a greater claim to the assets and earnings in a company. Additionally, this stock is great for shareholders when the company is in good times and there is excess cash to distribute between the investors through dividends.
Moving onto common stock, it represents the share of ownership in the corporation. It is the kind of stock that many people invest in. In fact, when people talk about stocks, they are usually referring to the common stock and a huge majority of stock is issued in this form. The common shares represent a claim on profits and confer voting rights. Investors get one vote per share owned for electing the board members who oversee the major decisions made by management.
This means that the common stockholders have the capability to exercise control over the company and management as compared to the preferred shareholders. Common stock also tends to outperform bonds and preferred shares. It is the kind of stock that offers the largest potential for long-term gains. This means that if the company does well, the common stock value will go up. But if the company does poorly, the value will also go down.
Preferred shares can be converted to a fixed number of common shares, but common shares don’t have this benefit. The board of directors of the company are the ones that decide if a dividend is to be paid to the common shareholders or not. As mentioned for preferred stocks, if the company misses a dividend, the common stockholders get bumped back after the preferred shareholders.
The claim over the earnings and income of the company is important during times of insolvency.
What is an RSU?
Another kind of share is an RSU (restricted stock unit). It is offered by the employer to the employees in the form of company stock. RSUs are issued to employees through a vesting plan, which is a distribution schedule. The employee gets the shares after they have reached the needed performance milestones set by the company and has stayed with the company for a specific period of time. RSUs offer the employee with an interest in the company’s stock, but it does not have any tangible value until the vesting has been completed.
These RSUs are given a fair market value the moment they vest and are considered as income. Due to this, a part of the shares is withheld to pay income taxes. The employee gets the rest of the shares and can sell or keep them. Just so you know, RSUs have become a very popular form of employee compensation recently. Before this, stock options were the thing. But due to the many issues that came with stock options in 2004, this kind of stock came into being to avoid these issues.
Understanding an ISO and NSO (Stock Options)
The next kind of shares are stock options. A stock option is a great way to motivate consultants and employees in a company. Options offer the right to purchase a set number of shares in the future when the stock of the company has become more vulnerable, and at a predefined low price. There are two kinds under this: incentive stock options (ISO) and non-qualified stock options (NSO).
To understand more, we need to understand the difference between the two kinds of stock options, as below.
1. Tax Liability
One of the main differences is the tax treatment between ISOs and NSOs. The stock from an NSO is taxed twice; first at the time of exercise and second when the stock is sold. The income for an NSO is the difference between the FMV and the exercise price. On the other hand, ISOs have fewer taxes as there are no taxes owed at the time of exercise. This kind of stock is normally subjected to long-term capital gains when it is sold.
2. NSO is Most Advantageous
For a company, NSOs are very advantageous since the company can take tax deductions when the consultant and employee exercise the stock option. The reason behind this is because with an NSO, the stock option is considered as ordinary income. On the other hand, an ISO doesn’t allow any tax deductions for the company.
3. ISOs are for Employees Only
ISOs are exclusively reserved for the employees in a company. On the other hand, NSOs can be granted to any service providers including consultants, contractors, directors, and employees.
4. ISO is not Subject to the Valuation Requirements of Section 409A
One of the main drawbacks of NSOs is that it requires the company to have a 409A valuation performed. However ISOs do not have such requirements and are less stringent. They are much more reasonable for a company.
Stock Options vs RSUs
With the above clear, let us understand the difference between RSUs and stock options. To begin with, stock options and RSUs are closely related, but they have many differences between them. When we talk about stock options, it means employee stock options given to high performing employees as a part of their remuneration.
For example, let’s say a company hires a new CEO and offers him 20,000 stock options. The company determines the term of the stock option in such a way that the CEO would be able to exercise his rights on the stock options after 3 years from his joining date. Now, the CEO receives the stock options at a flat rate of $4 per share. His purpose would be to increase the stock price as high as he can in the next 3 years. After 3 years, he can sell his stocks, let’s say at $15 per share and can make a profit of $11 per share. That is a huge profit.
Often stock options are offered to employees who perform exceedingly well. And also stock options are given at a discount rate (less than the price of the stock at that time) so that the stock option can be considered as a reward.
On the other hand, restricted stock units are offered to keep exceptional employees in the organization. But the way RSUs are constructed is different. RSUs are paid as per a vesting schedule and don’t offer all the shares together.
After reading this article, you now have an idea on the differences between common shares and preferred stock, stock options and RSUs. With this knowledge, you now know what you should offer the employees in your company as equity compensation. To learn more about equity compensation, check out the other knowledge-based articles here!