In the previous article, we have already studied about option pools. We now know the various advantages that they offer and why they are preferred by startup companies as a means to compensate their employees. However, some companies and investors are not happy with the concept of stock option pools. This is because they dilute the voting rights and also cost the company in the form of dividends.

Many employees do not like stock options either because they have to invest some money upfront in order to obtain a monetary benefit. As a result, over the years, a new concept called restricted stock option was born. Restricted stock options work a lot like stock options but have certain relevant restrictions.

In this article, we will understand the concept of restricted stock options and how they differ from traditional stock options.

What are Restricted Stock Options?

The concept of restricted stock options needs to be understood by contrasting it with regular stock options. Regular stock options allow the investor to buy a certain number of stocks at a price that is lower than the market value of the stock. This means that the employee has to pay a certain amount of cash upfront in order to realize the benefit.

Restricted stock options are a company’s promise to give the employee an amount equal to the value of the shares at a certain date in the future. Since the employee is not purchasing any stocks they need not put up any money upfront.

Difference between Restricted Stock Options and Option Pools

There are some key differences between restricted stock options and option pools. The details of these differences have been mentioned below:

1. Restricted stock options may be paid out either in cash or stock. This means that the employee may have the choice to obtain the stock of the company or they can choose to obtain the cash value of the stock. In both cases, they are at the receiving end and do not have to put up any money.

2. Stock options are not actual stock. Hence, they do not have any voting rights unless they are actually exercised and converted to common stock. Once they are converted to common stock they have the same voting rights as any other investor. However, when it comes to restricted stock options, the stock does not carry any voting rights. It is created to provide the employee with the monetary benefit without the management losing control of the company.

3. In order for the stock options to be exercised, the current market price of the stock has to be greater than the strike price of the stock plus the taxes that need to be paid. On the other hand, there is no strike price for restricted stock options. Instead, the company may agree to issue this stock once certain milestones have been reached. Hence, for example, if the revenue of the company has reached $1 million, then RSUs will be issued irrespective of the market price at that time

4. Also, in case of restricted stock options, the taxes become payable as soon as the company issues the stock or pays the cash equivalent. In the case of stock options, employees have the option to time the taxes which helps them lower their liability.

5. Common stock options do not receive any dividend until the stock is converted into cash. After that, they receive dividends just like a regular stock. On the other hand, restricted stock options never receive dividends. Companies may agree to pay a bonus that is equivalent to the dividend amount. However, they may not be under any obligation to pay dividends to the holders of RSU.

6. Since restricted stock options have to be funded in cash, they are preferred by late-stage organizations which have a stable cash flow and will able to pay out the value of the stocks. For companies that are cash strapped, the ability to pay in stock may be more valuable than paying the cash value of those stocks.

7. Stock options are considered to be more valuable in early-stage startup companies where the price of the stock is likely to rise in value over a short period of time. In such cases, employees will prefer stock options because of the higher potential upside.

8. Restricted stock options do not dilute the value of the underlying shares. They may not need to be displayed in the capitalization table since they are considered to be short-term liabilities rather than the capital of the firm.

The fact of the matter is that restricted stock options are preferred by companies in the later stages of their startup journey where they are sure about their cash flow and do not want to dilute the equity. Restricted stock options are a very important tool that is commonly used by mature startup companies to ensure that their workforce remains motivated and efficient.