What it means
The two dominant forms work quite differently. A share option gives the right to buy shares later at a price fixed today, so it is worth something only if the share price rises above that strike price, whereas a restricted share unit is a promise of actual shares and retains value even if the price drifts down.
Vesting is the mechanism that turns a grant into ownership over time. A common arrangement is four-year vesting with a one-year cliff, meaning nothing is earned in the first twelve months and then a quarter vests at once, with the rest accruing monthly or quarterly afterwards.
The business case is straightforward. A young company short of cash can pay a senior hire partly in ownership, keeping payroll manageable while tying that person's reward to the outcome shareholders care about.
The cost is not free, though it does not consume cash. Accounting standards require the fair value of the grant at the date of award to be spread as an expense across the vesting period, so profit falls even though the bank balance does not.
Existing shareholders also carry dilution, because new shares issued on exercise shrink everyone else's percentage. Tax treatment is where most misunderstanding lives, and it varies sharply by country and by instrument.
Employees frequently discover that exercising options creates a tax bill on paper gains long before there is any liquid market in which to sell the shares and fund that bill.
In practice
Real-world examples
Example 1
A seven-person analytics start-up hires a head of sales at $30,000 below market salary and grants options over 1% of the company on four-year vesting. The cash saving funds two more engineers while the sales lead has a direct stake in the exit value.
Example 2
A listed retailer pays half of its executive bonus in restricted share units that vest after three years. Because the units retain value even in a flat market, they act more as a retention tool than as a bet on the share price.
Example 3
A private business preparing for a sale discovers that a departing employee's vested options must be settled at completion. The buyer insists the cost is deducted from the headline price, which reduces the amount reaching the founders.
Think of it
Imagine baking a cake with your friends and agreeing to pay the baker in slices of the finished cake rather than pocket money. If the cake turns out huge and delicious, everyone's slices are worth much more.
Formula
Calculation
Annual share-based payment expense = (number of instruments expected to vest x fair value per instrument at grant) / vesting period in years. Dilution = new shares issued / (existing shares + new shares issued).
A company grants an engineer 40,000 share options with an exercise price of $10, valued at $6 each on the grant date, vesting evenly over four years. Total grant value is 40,000 x $6 = $240,000, so the annual expense is $240,000 / 4 = $60,000 charged to profit in each of the four years.
If the engineer later exercises all 40,000 options when the share price is $26, she pays 40,000 x $10 = $400,000 to the company and holds shares worth 40,000 x $26 = $1,040,000, a gross gain of $640,000 before tax. With 4,000,000 shares already in issue, the 40,000 new shares represent 40,000 / 4,040,000 = 0.99% dilution, so every existing shareholder's stake shrinks by just under 1%.Case study
Seen in the real world
Oakhaven Robotics is a fictional company invented purely to illustrate this term. To land an experienced controls engineer without breaking a tight payroll, it granted 40,000 options at a $10 exercise price when an independent valuation put the fair value of each option at $6.
The accounting effect surprised the founders. The $240,000 total grant value was expensed at $60,000 a year for four years, so reported profit fell even though no cash left the business, and the bank covenant that tracked reported profit came uncomfortably close to breaching.
Four years later the shares changed hands at $26 in a funding round. The engineer exercised, paid $400,000 for shares worth $1,040,000, and the founders accepted just under 1% dilution. In this illustrative case both sides felt fairly treated, largely because the vesting schedule and the tax timing had been explained clearly at the point of hire.
Watch out
Common mistakes
- Treating an option grant as equivalent to cash of the same headline value. Options are worth nothing unless the share price exceeds the exercise price, and they may never become sellable.
- Assuming equity compensation has no cost because no cash moves. The fair value at grant is charged to profit over the vesting period and existing shareholders bear dilution on top.
- Ignoring the tax point when options are exercised. In many jurisdictions tax falls due at exercise on the paper gain, even where no shares can yet be sold to pay it.
Questions
People also ask
What is the difference between an option and a restricted share unit?
An option is a right to buy at a fixed price and only pays off above that price, while a restricted share unit is a promise of shares that keeps some value at almost any price.
Why do companies use a one-year cliff?
It avoids giving away ownership to someone who leaves within months, so the first slice vests only once the hire has clearly worked out.
Does equity compensation reduce reported profit?
Yes, the grant date fair value is expensed across the vesting period, which lowers accounting profit without affecting operating cash flow.