Employee stock options explained: understanding stock options and employee benefits
Imagine that you worked for Google, Apple, or Yahoo back in the day when nobody realized how successful and powerful these companies would become…
Also imagine you were working at one of these companies and were offered stock options. What would you do? Would you ask yourself “Why are they offering me this benefit?” Stock options can be complicated and knowing what to do when you receive this opportunity, well, this can be very valuable information.
What are stock options?
Stock options are a benefit that many startup companies issue to reward early employees when and if the company goes public. Stock options are usually awarded by companies who are fast-growing companies as an incentive for employees to work towards growing the company's value.
Stock options are also used as an incentive to help companies keep their employees. The options cancel if the employee is not vested and leaves the company. ESOs do not provide any dividends or voting rights in this area they are like preferred stocks.
things to know about stock options
- Companies can offer ESOs as part of an equity compensation plan.
- These grants come in the form of regular call options and give an employee the right to buy the company’s stock at a specified price for a finite period.
- ESOs can have vesting schedules which limits the ability to exercise the options.
- ESOs are taxed at exercise and stockholders will be taxed if they sell their shares in the
open market.
Employee stock options (ESOs) are equity compensation given by companies to their employees and executives. They do not give shares of stock directly, the company gives derivative options on the stock instead. These options come in the form of regular call options and give the employee the right to buy the company's stock at a specified price for a finite period. Terms of ESOs are usually spelled out for an employee in an employee stock options agreement, a document you must have and retain.
The benefits of a stock option are realized if a company's stock rises above the exercise price. In most cases, ESOs are issued by the company and cannot be sold, unlike standard listed or exchange-traded options. When a stock’s price rises above the call option exercise price, call options are exercised, and the holder obtains the company’s stock at a discount. The holder may choose to immediately sell the stock in the open market for a profit or hold onto the stock for future gains and value.
Understanding ESOs
ESOs are just one kind of equity compensation a company may offer. Other types of equity compensation may include:
- Restricted Stock Grants:these give employees the right to acquire or receive shares once certain criteria are attained, like working for a defined number of years or meeting performance targets.
- Stock Appreciation Rights (SARs):SARs provide the right to the increase in the value of a designated number of shares; such increase in value is payable in cash or company stock.
- Phantom Stock:this pays a future cash bonus equal to the value of a defined number of shares; no legal transfer of share ownership usually takes place, although the phantom stock may be convertible to actual shares if defined trigger events occur.
- Employee Stock Purchase Plans:these plans give employees the right to purchase company shares, usually at a discount.
These benefits are provided by companies to have employees and stakeholders help to build the company and share in the growth and success.
Employees benefit of any type of equity compensation plans are:
- An opportunity to share directly in the company’s success through stock holdings
- Pride of ownership; employees may feel motivated to be fully productive because they own a stake in the company
- Provides a tangible representation of how much their contribution is worth to the employer
- Depending on the plan, it may offer the potential for tax savings upon sale or disposal of the shares
On the Employers side the benefits are:
- It is a key tool to recruit the best and the brightest in an increasingly integrated global economy where there is worldwide competition for top talent
- Boosts employee job satisfaction and financial wellbeing by providing lucrative financial incentives
- Incentivizes employees to help the company grow and succeed because they can share in its success
- May be used as a potential exit strategy for owners, in some instances
There are two main types of stock options:
- Incentive stock options (ISOs), also known as statutory or qualified options, are generally only offered to key employees and top management. They receive preferential tax treatment in many cases, as the IRS treats gains on such options as long-term capital gains.
- Non-qualified stock options (NSOs) can be granted to employees at all levels of a company, as well as to board members and consultants. Also known as non-statutory stock options, profits on these are considered as ordinary income and are taxed as such.
Important Note
There are two key parties in the ESO, the grantee (employee) and grantor (employer). The grantee—also known as the optionee—can be an executive or an employee, while the grantor is the company that employs the grantee. The grantee is given equity compensation in the form of ESOs, usually with certain restrictions, one of the most important of which is the vesting period.
The vesting period is the length of time that an employee must wait to be able to exercise their ESOs. Why does the employee need to wait? Because it gives the employee a reason to achieve and help the company grow and stay with the company. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant.
Vesting
Is complicated and you need to look at your agreement and company plan.
Taxation
Taxation is also something you need to keep an eye on and contact someone who can help you to determine how much and when you will owe the Tax Authorities.
Book a Call today and let’s discuss your options as they relate to stock options.
About the Author:
Lillian Meyers CFP®, CDFA®, EA is a financial planner in Sonoma, California helping clients with wealth events, planning for retirement, loss of a spouse or divorce. She has decades of experience assisting clients in living their best retirement life through the use of financial planning, investment management, and other sophisticated financial options.