Equity and Shares - Definitions

Equity, shares and stock

While the three words are often used interchangeably, there are subtle distinctions between equity, stock and shares. Stock refers specifically to equity that is traded or tradable, while shares refer to a number of shares in a company’s stock.

Equity is the value of a company’s assets minus its liabilities. Also known as shareholder equity, it is the amount of money that would be returned to shareholders in the event that a company folds. In this instance, its assets would be liquidated and its debts (i.e., liabilities) paid off. What remains is distributed among the company’s shareholders.

Stock options

Stock options (also known as share options or equity options, and often referred to simply as “options”) are frequently part of compensation offers.

Options are not the same thing as shares. Shares give you immediate ownership of a small part of the company. If you are offered 0.01% of a company’s stock, you immediately own one ten-thousandth of the company’s equity once you have accepted and the shares have been issued and allocated. In practice, it’s common to pay a nominal fee (1p, for example) for each share you are allocated.

Options, however, are contracts that give you the right to buy shares in the future at a specified price known as the “strike price.” You don’t own any shares until you exercise these options. Of course, if the value of the shares is below the strike price, it doesn’t make sense for you to exercise your options.

If, however, the market price exceeds the strike price, you effectively get a good deal on the shares. There are two important considerations to remember:

1. You will normally need to pay cash for the shares in order to exercise your options, so you will need to make sure that you have sufficient cash available if you wish to do so.
2. There can be significant tax implications if you exercise options to buy shares below their market value. Typically, you will be taxed on the difference between the market value and the strike price of the shares, and you will need to pay capital gains tax on any later increase in value if you sell the shares in future for a higher price.

Options usually have an expiry date by which they have to be exercised. In some cases, the options can only be exercised on this date (these are sometimes referred to as “European options,” as opposed to “American options” which can be exercised any time up until the expiry date).

Dividends

Shareholder dividends are payments companies make to their shareholders. They are taken out of shareholder equity - in effect, from the profit the company makes over any given period of time.

Not all companies that make a profit pay dividends. Many companies (especially smaller, growing ones) find it more prudent to reinvest their profits into, for example, marketing or R&D, in the hope of generating larger profits (and building more shareholder equity) in future.

Vesting period

Equity is usually offered by companies to give their employees material interest in the company’s long term success. For this to work, they need a mechanism that prevents the employee from leaving soon after starting the job, with the shares in their pocket, without having made a significant contribution to their future value.

This legal mechanism is known as a vesting period. It is a specified amount of time over which the employee gains control over the equity they are being offered. You might, for example, be offered 200 shares that vest over four years. If you leave the company after three years in this instance, you will only take 150 of the shares with you. (This is known as forward vesting. Reverse vesting gives you all the shares up front, but requires you to sell them back to the company at no profit in the event that you leave before the end of the vesting period.)

Cliff

It's unusual for vesting periods to begin as soon as you join a company. There is usually a period of time - often one year - before your shares or options start to vest. This period is called a "cliff".

If, in the example under "Vesting periods," the equity had a four year vesting period and a one-year cliff, you would start accruing shares after 12 months at the company. You would receive 50 shares, and the remaining 150 shares would then be allocated over the following three years.

Key insights

• While they are often interchangeable terms, there are subtle differences between “equity,” “shares” and “stock”

• Stock options are contracts that allow the holder to buy shares in the future at a pre-agreed price

• Vesting periods and cliffs dictate the amount of time employees need to spend at a company before they start accruing equity

References

1. https://www.investopedia.com/terms/e/equity.asp
2. https://www.fpmarkets.com/uk/stocks-vs-equity/
3. https://www.investopedia.com/ask/answers/difference-between-shares-and-stocks/
4. https://seedlegals.com/resources/shares-vs-options-whats-the-difference/
5. https://codersera.com/blog/equity-vs-stock-option/
6. https://www.investopedia.com/terms/v/vesting.asp