Top executives often receive equity in the company as a large proportion of their total compensation. Which equity instruments corporations use to make those equity awards has changed significantly over the past decade. The use of Stock Options (SOs), where executives have the right to purchase company stock at a certain price after vesting, has dropped dramatically, being replaced with Restricted Stock Awards (RSAs), where, after vesting, ownership of the stock is automatically transferred to executives.
ERI Economic Research Institute has documented changes in top executive compensation since 1997, when RSAs comprised about 10% of the average top executive compensation, and SOs represented 43%. By the end of 2010, the picture was dramatically different. RSAs accounted for 31% of total compensation, while SOs were only 27%. There are some good reasons why RSAs are often a more attractive form of equity compensation for both employers and executives.
The Executive Perspective:
When companies issue SOs and business performance doesn't improve, executives have options that are worth nothing. Even if the stock price is higher than the award price, executives have to take action to realize a benefit. RSAs, on the other hand, are never underwater and, when vested, do retain value, even if the value is less than the stock price when awarded. Also, there are some tax rules where executives can have a more favorable effective tax rate once the RSA is vested by filing certain information with the IRS and the employer within 30 days of the grant. (See http://www.fairmark.com/execcomp/sec83b.htm for more information on this Section 83(b) election.)
The Employer Perspective:
Equity compensation is intended to motivate executives to stay with the company and make decisions from an owner's viewpoint. The accounting cost of SOs are less than RSA, so organizations will award more SO than RSAs. The larger grant sizes coupled with lucrative upside, SOs can foster more risk taking where executives can artificially inflate the stock price for personal gain. On the other hand, since RSAs tend to be smaller grants, they are less dilutive and are preferred among executive populations that have conservative business practices.
An SO is granted at $20 per share but trades at $10 when the option vests. The stock option is worth $0.00. However, an RSA granted at $20 that trades at $10 when vested is still worth $10. The SO is underwater and has no value, while the RSA has retained 50% of its value.