Companies give out stock grants and stock options for the same reasons: to compensate or reward people for the work they've done, as an incentive to keep people with the firm or to motivate people to work to improve company performance. The fundamental difference between them is that with a stock grant, you receive shares of stock, while stock options give you a chance to buy shares.
Consider also: The Disadvantages of Investing in the Stock Market
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How Employee Stock Grants Work
When a company issues employee stock grants, it either gives you shares or, as is usually the case, promises to give you shares provided you meet certain conditions. Those conditions may be time-based, such as remaining with the company for a certain period, or performance-based, such as meeting sales targets.
Grants with conditions are referred to as "restricted." Grants become unrestricted, or "vested," when you have met all conditions and are free to do whatever you want with the stock – such as sell it.
Stock grants tax treatment is fairly straightforward. At the time shares vest, the fair market value of the stock will be taxed as ordinary income. So if you have 100 shares vest, and the share price at the time is $25, then you will owe taxes on $2,500 worth of income.
How Stock Options Work
When a company issues stock options, it is giving you the right to buy shares later on at a specific, predetermined price. If this "strike price" is lower than the share price of the stock at the time you exercise the option, then you get to buy stock at a discount. If the share price is lower than the strike price, the option is worthless. However, you aren't required to exercise the option – that's why it's called an "option."
Options have vesting periods just like grants do. You might receive an option, but you can't exercise it for, say, two years.
Consider also: What Is the Meaning of Vesting Date in Stock Options?
Tax Treatment of Stock Options
The tax treatment of stock options depends on whether they are "incentive stock options" (also called qualified or statutory options) or nonstatutory options.
With incentive options, you generally incur no tax when you receive the option or when you exercise it. When you sell the stock later, capital gains tax will apply to the difference between the strike price (what you paid for the stock) and the sale price (what you got when you sold).
With nonstatutory options, you incur no tax when you receive the option. When you exercise the option, the difference between the strike price and the share price – your discount, in other words – is taxed as regular income. When you sell the stock, the difference between the sale price and the share price when you exercised the option is treated as a capital gain.
Consider also: Do I Pay FICA Taxes on Stock Options?
Deciding Stock Grant vs. Stock Option
Using stock rather than cash to compensate, reward or motivate people is attractive to companies that don't want to part with cash – especially startups, which may have weak cash flow as they get off the ground.
Whether a company uses grants, options or a mix of the two depends on its particular circumstances and the prevailing philosophy of its management. A startup may prefer options, for example, since they will have value only if the company succeeds. A mature company whose stock price isn't likely to skyrocket may opt for restricted grants.
Employees don't typically get to choose whether they get options or grants, but each has its advantages. As long as the company's stock has any value at all, a stock grant has value, too. An option may become worthless if the share price doesn't rise above the strike price during the period when the employee can exercise the option. But options may have more room to grow, especially in young companies.