How are options different from shares?

How are options different from shares?

Options, shares, a share of an option? An option on a share? Who am I sharing with? What options do I have? Do I have the option to share? Yes - language can be confusing, and yes, the finance profession can use language in even more confusing ways. We know the world of employee equity programs is confusing, that's why we have figured it out for you and will break it down here.

Why is it so complicated?

Maybe you have just received some options (hooray for you!) or maybe you are considering a job that says there is an options pack included and you thought “what the $%&# are options?”

It is a fair question and like every profession, complicated words and phrases are used to make things seem more scary than they are. You could try and read into why this is, maybe they were neglected as a child (no ice cream for Timmy!), or have a superiority complex (I am a nourishment consultant… you mean a waiter?). Regardless, many industries suffer from this compensation-via-over-complexation syndrome. This is particularly in the finance world, think credit default swaps, special purpose acquisition companies, and share based compensation. Uh oh - the last one actually has to do with options - ahh more lingo!

Not to stress! Pomello is here to help.

Options - what?

Options are a type of financial instrument. What is a financial instrument? Some sort of piano? No, again it's an over-complicated way making something of value tradable. Money is a financial instrument, so are shares (You’ve probably heard of Gamestop?), even cryptocurrency. These financial instruments come in many shapes and sizes, with options being one of them. Options are slightly more complicated, because they are, what the name says, an option to buy something, such as a share.

So what's the difference?

Shares are a portion of ownership in a company. When you own some of the company, you can then participate in the growth of that company by being a shareholder. There are many different words used to describe shares, such as stock, equity, capital, but they all essentially boil down into the same thing. Shares are a great way to build wealth, and is the primary way that basically every rich-lister has made their wealth, less the ones who inherited it (looking at you Walton family). Jeff Bezos doesn't have $100 billion in the bank, he has $100 billion worth of Amazon shares.

Options are the option to buy shares at a set agreed price. Picture this, you wake up in a cold sweat - we truly are in the matrix!! Soon everyone is going to be offered the choice between a red and blue pill and you are the first to notice. You want to invest in Red and Blue Pill Inc, the biggest manufacturer of matrix pills, but you are unsure if it's actually going to pan out. Maybe it was just a mad dream. Instead of buying shares in the company, you could buy options in the company, which gives you the right but not the obligation to buy shares in Red and Blue Pill Inc at a price agreed upon today. If you are right, the price of Red and Blue Pill Inc skyrocket, you have locked a price in now. If you are wrong, and the matrix does not exist, you have only lost the cost of the options (which is usually much less than the price of the shares). That's why options are always described as the right, but not the obligation, to purchase shares in the future at an agreed price now.

Yeah sure, the Matrix ‘ha-ha’ - but how does this apply to my company?

One way to reward you for working in a company, and particularly in a start-up company, is through options in the company. This means that if the company succeeds in a few years, so do you, because you were given shares in the company at an earlier price. But why options and not equity? Options are mainly used for tax reasons. Shares are classified as an asset, so can be subject to various different kinds of taxes, such as asset taxes and capital gains taxes. Options on the other hand are more favourably looked upon by the tax department, because they are not an asset until you have converted them into shares - which basically just buys you more time.

Converted into shares - how do you convert?

Great question. Options have a lot more terminology surrounding them than shares, which we cover in later articles. The terminology includes words such as vesting schedules, cliff dates, striking options, expiration dates, etc. All will be explained later, but what's important to understand is the difference between shares and options.

Conclusions

Yes, conclusions. You’ve made it to the end, wehuu.

Both shares and options are financial instruments. A share is a direct ownership of a company, whereas options are an agreement for the right but not the obligation to buy shares in the future at a price agreed now. Options are a great way to be involved in the growth of any company, and are particularly good ways of rewarding employees of start-up companies that are cash strapped.

If you would like to find out more about everything at the nexus of options and start-ups then give us a bell. We are experts in employee equity schemes, of share based compensation, or however you want to call it because your uncle never took you seriously as a child.