The difference between shares and share options lies in ownership in the company and the vesting method.
Ownership in the company
Once shares have been issued and allotted, the individual immediately becomes a shareholder. They enjoy the rights of shareholders, eg voting rights and rights to dividends.
On the other hand, an individual granted with share options doesn't become a shareholder immediately. Instead, they’re granted with rights to buy shares in the future (after a ‘vesting period’) at a set price. They must exercise the options in order to convert them into shares.
Vesting refers to a process where an individual’s entitlement to the relevant shares or options is granted over time. This mechanism prevents shareholders from suddenly walking away with a large stake in the company, rendering the company not investable. It also encourages employees to stay with the company longer so that they can fully earn options available to them.
Shares typically vest by reverse vesting. This is where individuals become shareholders immediately upon allocation. However, if they leave before a defined (‘vesting’) period, they will be required to sell the unvested shares back to the company.
For example, John is issued and allocated 1,000 shares with a reverse vesting period of 5 years. This means 200 shares are vested annually. So if John leaves after 2 years, the company can repurchase the 600 shares which haven’t been vested yet.
Options vest by forward vesting. This is where individuals are granted options gradually over a specific period of time.
For example, John is rewarded with 1,000 options with a vesting period of 5 years, ie 200 options are vested annually. If John leaves after 1 year, he will only be entitled to 200 options. The remaining 800 unvested options will return to the total employee option pool.