These options are granted to employees of a company as a form of compensation as well as motivation
Quang Nguyen Vinh from Pixels; Canva
What Are Employee Stock Options? Where Do They Come From? How Much Are They Worth?
As an incentive to work hard and help their company grow, employers often give their employees equity compensation in the form of stock options.
Just like financial options, employee stock options are contracts that give stakeholders the right to exercise a set number of company shares. These shares are valued at a predetermined price, known as the strike price, over a distinct timeframe, called the exercise period.
The strike price is usually the market price that the stock was valued at when the option was granted. If an employee sells the option at a higher price than they paid to exercise it, they will profit. The term that is used to describe the difference between the price they paid and the price they exercise is known as the spread.
The timeframe when employees can exercise their options is known as the vesting schedule. The equity grant agreement details the grant date, the number of options granted, the strike price, as well as restrictions such as the minimum amount of time the options must be held in order to exercise them. This time period is usually between one and three years, although some contracts allow a certain percentage of the options to be exercised after one year, an additional percentage after two years, etc.
Options that are valued below the stock’s current price are known as being in the money.Options that are valued above the stock’s market price are known as being under water, or out of the money. Often, when this happens, a company will reprice its options so that employees can trade them in profitably.
If the employee leaves the company before the options vest, they become cancelled.
How Do Stock Options Work for an Employee?
Here’s an example of an employee stock options contract.
An employee is granted 1,000 stock options, vesting over 5 years. The strike price is $100 per share. Under a phased vesting schedule, 20% of the shares (or 200 options) vest per year,. If the stock price rises above $100 per share, the employee would be able to exercise them for a profit. If they don’t rise above $100, it would be better to let them expire.
What Are the Two Types of Employee Stock Options and How Are they Taxed?
There are two main categories of employee stock options, and their differences are based on taxation.
1. Nonqualified Stock Options (NSOs) are taxed when you exercise the option. The spread gets taxed at normal income rates, as the IRS considers it to be part of an employee’s standard income—their compensation.
2. Incentive Stock Options (ISOs), on the other hand, are taxed differently because they are not taxed when they are exercised. Usually, these options are reserved for the company’s executive team. If these options are held for more than 2 years, they are subject to the alternative minimum tax, which is a more favorable, longer-term tax rate.
Can Employee Stock Options Be Transferred?
It depends on the type of stock options, as well as the employer. Employers generally allow stock options transfers on a limited basis.
Stock options that are transferrable are usually treated as NSOs for taxation purposes.ISOs are transferrable to family members only in the event of the death of the employee. These stock options are typically subject to the estate tax.
When Do Employee Stock Options Expire?
If an employee leaves the company, their window to exercise any remaining options is usually 90 days.An equity grant agreement specifies the exercise period for the employee stock options. The maximum length typically does not exceed 10 years.
Are Employee Stock Options Good or Bad? Which Employees Get Them?
Employees at every level of a business are eligible to receive employee stock options, and they can be granted to employees, consultants—even board members and company investors. However, any corporate director who holds greater than 10% of the company’s outstanding shares is not eligible to receive employee stock options.
Not all employers offer employee stock options, but for those that do, it can be a great motivator for an employee to work as diligently as they can to increase the company’s value as quickly as possible. Sometimes, profits from stock options can exceed a top-tier employee’s base salary, and they could enjoy tax advantages, as well.
For an employer, especially a startup, employee stock options may be an attractive form of compensation to entice a talented employee to join their ranks, as they otherwise might not afford to offer the position at market rates.
But just as there are benefits to employee stock options, there are also risks—the greatest being if a company fails to live up to analyst expectations, and thus the employee stock options never exceed their exercise price. When that happens, the options have no value.
In addition, if a company is on a downward trend in its life cycle, is operating during a bear market, or declares bankruptcy,its employee stock options will most likely be rendered worthless, making it quite risky for any employee to agree to receiving sole compensation in this manner. Before they sign on the dotted line, they should be sure to do their homework.
