Employee stock options have been a common equity compensation form to entice, retain and motivate employees. They’re not just for tech companies or small businesses but can also help any business thrive.
What are employee stock options?
Employee stock options are an equity award that gives you an opportunity to exercise (i.e. purchase) a certain amount of shares in your company at an agreed price at a future date (i.e. exercise date). That price is called the exercise price or strike price. In the US, the exercise price is typically set at the fair market value of the underlying stock as of the date the stock option is granted.
Whenever the stock’s market value is greater than your exercise price, your option is said to be “in the money.” Conversely, if the market value is less than your exercise price, it is called “underwater”. Holding underwater stock options long is not ideal for option-holders. Some companies may allow you to exchange your underwater options during times of stock market volatility.
Types of employee stock options
There are two key types of employee stock options: incentive stock options (ISOs) and nonqualified stock options (NSOs).
- ISOs can only be given to employees with a more favorable tax treatment but ISO holders are subject to alternative minimum tax (AMT) which can be a complex tax event. ISOs also come with more restrictions like a $100,000 grant limit and exercise price limit.
- NSOs can be given to non-employees like directors and vendors. They also have fewer restrictions and an easy-to-understand tax structure but don’t qualify for the favorable tax treatment given to ISOs.
Learn more about ISO vs NSO.
How do employee stock options work?
No matter which type of options you hold, there’re typically four stages in the life cycle of employee stock options: Grant➜ Vesting➜ Exercise➜ Sale
1) Grant: Employee stock options are awarded at an exercise price. It’s usually equal to the stock’s market value at the time the option is granted.
2) Vesting: Vesting is a waiting period to earn the right to exercise your options. It can be a time-based or performance-based process. Check out our ‘’What is Vesting’’ guide.
3) Exercising: Once the vesting period has passed, you can exercise your stock options at the exercise price. (Note: some companies allow you to early exercise your unvested option shares.) When you exercise your option shares, you may be taxed depending on which stock option type you hold.
4) Sale: You can sell your shares right after exercising or hold on to your shares. When you sell your shares, your capital gains will be taxed.
Benefits of stock options for employees
Enjoy financial rewards
Compared to cash bonuses, equity-based awards like stock options can potentially provide employees with a significant return on investment if the company is a success. That explains why Facebook has created many millionaires from stock options. (Important note: Companies can also fail and their value can drop.)
Incentive stock options (ISOs) are tax-efficient employee stock options. No income is recognized for regular tax purposes at the time of exercise although you may have to pay AMT at exercise.
If you hold on to your shares for a certain time, you only owe long-term capital gains at sale. Long-term capital gains are taxed at a favorably low rate.
Benefits of stock options for employers
Think like owners
Stock options give employees an opportunity to have ownership in the company. It means they are likely to behave as an owner and align with the company’s missions. They are going to weigh their decisions according to what will help the company best.
Better employee morale and motivation
The better the company does, the greater its reward. Employees are incentivized to work harder and be more productive as their performance can impact how much they can earn.
Improve employee retention
Stock options likely increase staff retention because most employee stock options vest over a number of years. In most plans, participants receive a part of the grant each year over a number of years. This gives the participants a great incentive to stay with the company for longer. If they leave early, then they won’t receive the full value of their award. At an up-and-coming startup, that could mean leaving a lot of money on the table.
Simple tax treatment and flexible
Non-qualified stock options (NSOs) are a straightforward employee stock option award although it’s not as tax-advantaged as ISOs. NSOs have a simple tax structure that can be easily communicated. NSOs are also flexible without many restrictions such as eligibility and grant limits.
Any downsides of employee stock options?
Employee stock options can be a helpful way to make your company thrive. With an ownership-focused mindset, you can help improve your staff’s happiness and incentivize them to work harder. However, there are some downsides:
- Options being worthless if the stock value of the company doesn’t grow
- The possible dilution of other shareholders’ equity when option-holders exercise their stock options.
- Complex tax implications for ISOs, especially the concept of AMT.
- Extra management and administration workload to your existing departments – everything from tracking and reporting changes in ownership to updating documents/policies/procedures, communicating with stakeholders, consulting your board of directors, and staying compliant. Luckily, stock option management can be easier with an automated and smart equity management platform and a team of experienced equity professionals.
We can cater to every plan complexity and award type imaginable.
Key things to know before accepting stock options
- Type of employee stock options to be accepted:
Will you be granted incentive stock options (ISOs) or non-qualified stock options (NSOs)?
- Number of stock options to be accepted:
This number is important to determine your total compensation package. You also need this to figure out how much you have to pay if you want to exercise your options someday. [Total exercise price = No. of options x Exercise price($)]
- Exercise price or strike price:
Every employee stock option has an exercise price which is the price at which a share can be bought at an exercise date.
- Vesting schedule:
Vesting is a process of earning the ownership of your equity. A common vesting schedule for stock options is 4-year vesting schedule with a 1-year cliff.
- Vesting Commencement Date
- Methods to exercise options
Some common methods include monetary payment, sell some to cover and exercise and sell all. Some companies allow for early exercise. View different methods of exercising stock options here.
- Expiration date
Employee stock options often expire 10 years from when they’re issued if they are not exercised.
- Time allowed to exercise upon termination
If you leave the company, you typically have a window of 90 days to exercise your options. If you don’t do so within the timeframe, your options will expire.
- Transferability restrictions
At Global Shares, we have over 15 years of award-winning equity compensation management experience. Our teams of specialists will take you through implementation, where we work with you to design and launch your employee stock option plan, as well as the day-to-day business of administrating and improving your plan after launch.
Contact us for a no-commitment demo today.
FAQs about employee stock options
How does an employee stock option work?
There are typically four stages in the life cycle of employee stock options (ESO): Grant, Vesting, Exercise and Sale. At grant, ESOs are awarded at an exercise price. Then, you earn the right to exercise (i.e. purchase) your options at the exercise price once vesting has passed. You can sell your shares right after exercising or hold on to your shares.
Which employees get stock options?
ESOs are usually granted to key employees and senior managers.
What are the advantages of stock options for employees?
ESOs can improve employee retention and motivation. Employees are also likely to think like owners to weigh their decisions according to what will help the company best. For employees, ESOs can be a good way to build wealth while enjoying tax benefits.
What are the disadvantages of employee stock options?
Existing shareholders may not be happy about equity dilution. ESOs can also cause extra management and administration workload to your existing departments
How are employee stock options taxed?
For ISOs, there is no income recognized for regular tax purposes at the time of exercise but you may have liability for AMT. If you hold onto your shares for a certain amount of time, your capital gains will be taxed at a lower capital gains tax rate. For NSOs, you’ll be taxed as ordinary income when you exercise your options. If you hold your shares for at least one year of exercising, you’ll be taxed as long-term capital gains on sale.