Everything You Need to Know About Employee Stock Options

When it comes to employee stock options, no one is more famous than the artist, David Choe. Commissioned to paint a mural on the walls of the Facebook offices in 2005, he opted to be paid in stock instead of money. Seven years later, when Facebook went public, Choe found himself the owner of $200 million worth of stock. Today, a  stock option  is one of the most common types of employee equity compensation, but it’s not always clear how they work.

Notably, employee stock options are  not  actual shares. They are an opportunity for employees to exercise (purchase) a specified amount of company shares at an agreed-upon price (the strike price) with the hope that they will sell their purchased shares for a higher price than they paid for.

Read on to see the most common types of employee stock options explained, plus advice on taxes and establishing a strategy for your company.

How do employee stock options work?

A stock option is a contract that enables an employee to purchase a given number of shares of a company at a determined price, referred to as the strike price, and within a specified time frame called the exercise window.
A company typically awards employee stock options through grants. Your grant provides all details of your equity plan, including how the company will award the equity compensation.

It may include crucial details such as:

• The grant date: When your stock options are granted
• The number and type of options granted to you
• The strike price/exercise price: The cost of buying the stock options
• Vesting schedule: When you’ve earned the right to buy stock options
• The exercise window: Once you’ve earned the right to buy, when can you buy?
• The expiration date: When will you no longer be able to buy stock?

You’ll also be given information on extenuating circumstances, such as:

• What happens if you’re terminated?
• What happens if there’s a change of control in the company you’ve vested in?

Notably, before you earn the right to exercise, your stocks have to vest first. Vesting just means you have to work for a company for an agreed period if you want to become an owner. Once your options vest, you gain the ability to exercise them. This means that you can now buy shares of the company's stock.

Essentially, the rules that guide and regulate employee stock options are imposed by a company's discretion and the existing tax and securities laws of a given jurisdiction. So if you’re an employee planning on buying stock options, you should read up on all the relevant details at your company to ensure it’s right for you.

Types of employee stock options available for employees explained

The two main types of employee stock options are:

• incentive stock options   (ISOs)
• Nonqualified stock options (NSOs)

The primary difference between the two stock options lies in how the stock options are taxed.

Incentive stock options (ISOs)

With ISOS, you typically qualify for special tax treatment when you hold onto your shares for a specified period, usually a minimum of one year after exercising and two years after your grant date. This means that you won't have to pay taxes when you buy. However, you may be required to pay alternative minimum tax (AMT) if you fail to sell your shares within one year after you exercise them. You must also pay regular income taxes if sold before then.

Nonqualified stock options (NSOs)

This option requires you to pay taxes both when you exercise and sell your employee stock options. NSOs are typically taxed as regular income and require the difference between the stock's market value and the exercise price. With this option, you have to pay short-term capital gains on shares that you sell within one year of the exercise date, as well as long-term capital gains on shares that you sell after at least one year.

Additional employee stock options: Types of equity compensation and their benefits

Restricted stock units (RSUs)

Restricted Stock Units (RSU) is an employee stock option issued to an employee in the form of company stock or shares. The restricted stock units are typically administered via a vesting plan and a specified distribution schedule that stipulates the performance milestones that an employee must achieve or an agreed length of time upon which an employee has to remain with their employer.

Although RSUs give employees interest in company shares, they typically don't have real value until vesting is complete. Once they vest, they are considered income, with a portion being withheld to cover income taxes. The employee can sell their stock options as they wish.

Employee stock purchase plans (ESPPs)

An Employee Stock Purchase Plan (ESPP) is a company-run program that gives employees the option to purchase company stock at a discounted price. This could be as much as 15% lower than the market price.

As an employee, you contribute to the plan via payroll deductions lasting from the offer date to the purchase date. At the purchase date, the company uses your accumulated funds to buy a specified number of stocks in the company on your behalf.

Performance shares

As the name suggests, performance shares are shares of stock granted to employees once they achieve predetermined performance objectives over a given period. They are incentive-based forms of stock compensation meant to drive employees of a company to achieve specific benchmarks.

Performance shares are usually granted if a company achieves particular metrics—for example, if the company's stock attains a desired value on the market or if the management team completes a campaign or project within a specified deadline.

The pros and cons of employee stock options

If you’re unsure whether employee stock options may be right for you, or your employees, we’ve compiled a list of pros and cons to consider.

Pros of employee stock options

Financial rewards

While not guaranteed, the potential for financial gain can be much more than cash bonuses or other forms of remuneration. If a business is successful, it can turn employees with stock options into millionaires.

Tax benefits

ISOs can be a better option for employees who want to reduce the costs of tax. If employees retain their shares for a set period, when it comes time to sell, they may only have to think about long-term capital gains—taxed at a lower rate.

Invested employees

Employees with stock options in the business are more likely to care about the direction and success of the company. This means they’ll have a vested interest in seeing the business thrive.

Increase retention

Many employees will want to vest their stock options over a long period, allowing them to buy more stock. In theory, employees won’t want to leave money on the table when they leave a business, so they’re more likely to stay to see their hard work come to fruition.

Cons of employee stock options

May not come to anything

If your company doesn’t grow, the stock options may not be worth much. While you’ll naturally work hard to prevent this, it’s a real possibility for any business.

Extra management and workload

Managing employee stock options, whether that’s updating policies, tracking and reporting or simply remaining compliant, can amount to a lot of extra work. Factor in the additional work needed into your current load before deciding whether it’s right for you.

How to create an employee stock option plan: 4 steps

If you are a C-suite leader, considering adding an employee stock option to your compensation plans, use the following steps to get started:

Step 1: Set up

Determine the best way to balance cash and equity compensation. Next, adapt your stock plan and option agreements before seeking approval from the stockholder and the company board. At this point, you should also acquire all the relevant permits and certifications from the concerned regulatory bodies.

Step 2: Maintenance

This step focuses on all the items you need to monitor on an ongoing basis. In essence, you must establish a method to keep your valuation up to date. Determine the number of stock options needed for new employees and establish a robust stock option pool.

Step 3: Making offers

This step builds an ideal checklist to give future employees option grants. The checklist should cover essential items such as budget, confirmation of employee details, and the grant size.

You should make sure you have enough shares to offer to new employees and confirm the legal status of the prospective employee before making an offer. When offering the grant, state that the terms of the shares are subject to board approval.

Step 4: Finalizing the grant

Have an expert re-evaluate the 409A to ensure it’s free of errors and to seal loopholes. You should then ask the board to approve the employee's stock option grant. Once this is done, process and execute the agreement before you finally update the company cap table.

How do employee stock options work after a team member leaves the company?

If an employee leaves the business, what happens to their stock? And what steps do you need to take as an employer?

First, there’s often an expiration date on employee stock options, typically ten years after the grant date. However, it’s important to check this before offboarding, as there can be some variation.

If the employee chooses not to exercise their stock options before this date, they’ll lose the opportunity to do so. If an employee is leaving your company, their expiration date will be brought forward, typically detailed in a planned document from HR.

My employees have employee stock options. Should they exercise them?

Generally, it's best to wait for the company to issue an initial public offering (IPO), assuming there are plans for the company to go public. Even after the company goes public, you should wait for the stock market price to rise above your exercise price before you exercise your options. If your company has no immediate plans to go public, it's best to wait for indicators that point to a climbing stock price before encouraging your employees to purchase shares.

Recommend that they talk to an experienced tax advisor who can help them figure out the best time to exercise.

What are the tax implications of exercising stock options?

You must pay taxes once you exercise or sell your stock options. The amount of tax you pay depends on the type of stock options you have and the length of time between exercising and selling.

If you exercise stock options as an employee and sell within one year of the exercise date, you must report the transaction as a short-term capital gain. This form of capital gain attracts the regular federal income tax rates.

If you decide to sell your shares after one year of exercise, the sale is considered a long-term capital gain that attracts lower tax rates than the regular rates. This implies that holding your shares for at least one year can help you save money on taxes.

Next steps: Will you offer employee stock options?

Undoubtedly, an equity compensation plan is a valuable part of a company's employee benefits. From the company's perspective, equity compensation plans offer employers alternative ways to incentivize their employees without hurting their bottom line. It also aligns the employee's self-interest with the company shareholder's self-interest.

Additionally, equity compensation helps a company attract and retain highly talented employees. From the employee perspective, equity compensation provides investment opportunities with no downside risks. It also offers several tax benefits.