Employee stock options (ESOs) are a form of equity compensation granted by companies to their employees. ESOs give employees the right to purchase a certain number of shares of the company's stock at a fixed price (the "strike price") for a certain period of time. ESOs are often granted as part of a company's stock option plan. Show
Who uses Employee Stock Options?Employee stock options are most commonly used by high-level employees of a company, such as executives or managers. These employees are typically given the option to purchase shares of the company at a set price, which is usually lower than the market price. This allows the employee to buy the shares at a discount and then sell them at the market price, which can result in a profit. Employee stock options can also be used as a form of compensation, especially when the company is doing well. What are the benefits of Employee Stock Options?Employee stock options (ESOs) are a form of compensation that give employees the right to purchase shares of the company's stock at a fixed price, usually lower than the market price. ESOs can be a powerful incentive to work hard and stay with a company, since they offer the prospect of a large financial gain if the stock price rises. They can also be a way for a company to give its employees a piece of the company's future success. How do you set up an Employee Stock Option plan?An Employee Stock Option plan, or ESOP, is a retirement plan that allows employees to purchase company stock with pre-tax dollars. The plan works by allowing employees to purchase shares of the company at a discounted price. The company then contributes the difference between the discounted price and the market value of the shares to the employee's retirement account. Employees can then choose to cash out the shares when they retire or leave the company, or they can continue to hold the shares and receive dividends.
Most options are granted on publicly traded stock, but it is possible for privately held companies to design similar plans using their own pricing methods. Usually the strike price is equal to the stock's market value at the time the option is granted but not always. It can be lower or higher than that, depending on the type of option. In the case of private company options, the strike price is often based on the price of shares at the company's most recent funding round. Employees profit if they can sell their stock for more than they paid at exercise. The National Center for Employee Ownership estimates that employees covered by broad-based stock option plans receive an amount equal to between 12 and 20% of their salaries from the "spread" between what they pay for their option stock and what they sell it for. Most stock options have an exercise period of 10 years. This is the maximum amount of time during which the shares may be purchased, or the option "exercised." Restrictions inside this period are prescribed by a "vesting" schedule, which sets the minimum amount of time that must be met before exercise. With some option grants, all shares vest after just one year. With most, however, some sort of graduated vesting scheme comes into play: For example, 20% of the total shares are exercisable after one year, another 20% after two years and so on. This is known as staggered, or "phased," vesting. Most options are fully vested after the third or fourth year, according to a recent survey by consultants Watson Wyatt Worldwide. Whenever the stock's market value is greater than the option price, the option is said to be "in the money." Conversely, if the market value is less than the option price, the option is said to be "out of the money," or "under water." During times of stock market volatility, a company may reprice its options, allowing employees to exchange underwater options for ones that are in the money. For example, if options were originally exercisable at $50, and the stock's market price dropped to $30, the company could cancel the first option grant and issue new options exercisable at the new $30 share price. It may sound like cheating, but it's perfectly legal. Outside investors, however, generally frown upon the practice -- after all, they have no repricing opportunity when the value of their own shares drops. Stock options allow employees to buy a piece of your company at a discount in exchange for their dedication and commitment. As a small business, you can consider offering stock options as a great way to compensate employees and help build a hardworking and innovative staff. Stock options are an employee benefit that grants employees the right to buy shares of the company at a set price after a certain period of time. Employees and employers agree ahead of time on how many shares they can purchase and how long the vesting period will be before they can buy the stock. All of this information is included in a contract that both parties sign. Employees have to purchase the stock before the vesting period ends or they will lose their right to the stock options. Additionally, employees are not obligated to purchase company stock, even if they have stock options. You don’t have to offer stock options to every employee, and many companies choose to offer stock options only for a few key positions. Related: Considering Sharing Profits? Things to Consider Benefits of offering stock options to employeesStock options are meant to give employees an incentive to work with a company and invest in its growth. They are a cost-effective way to attract talented candidates and encourage them to stay long-term. Employees who own shares of stock have an additional financial incentive for performing well at work beyond their regular salary. They want to help the company grow so the stock price will go up and they can make a significant profit on their initial employment package. Stock options also can provide protection for employers by requiring the employee to work with the company for a certain period of time before receiving access to their stock options. This protects the company’s equity and can help limit employee turnover. Stock options are also cost-effective since the business owner offers the future value of their company’s equity instead of cash upfront. They are common in startups when the company may have limited capital to pay employees, so instead, they offer a potentially valuable share of stock at a discount. Related: How to Set Up a 401(k) Plan for Your Business Drawbacks of providing stock optionsThere are some risks and repercussions of providing stock options. Giving away equity in your company through stocks can dilute your ownership in the business and limit your future profits if your company becomes successful. The less ownership you have, the less equity you have to offer to investors to grow your business. How do stock options work?Here is an example of the entire stock options process to help you understand how they function in a business: Pinkchip Tech hires Pamela Brito as a manager during the startup phase of their business. In her employment contract, they include terms that offer Pamela the option to purchase 25,000 shares of Pinkchip Tech stock at 15 cents for each share. The contract states that Pamela’s stock options have a four-year vesting period with a one-year cliff. This means that after one year of working at Pinkchip Tech, Pamela will have access to one-fourth of her shares. She could buy 6,250 shares for $937.50 at 15 cents each. The remaining 18,750 shares would then vest at a consistent rate over the next three years. If she leaves her job before the one year cliff, she won’t be able to exercise her options. Once Pamela exercises all of her shares, she owns a small percentage of equity in the company that she can sell to others. After four years, she can purchase all remaining shares. If the company becomes successful and later the shares sell at $10 per share, Pamela can sell the shares she purchased for a profit. Types of stock optionsYou can offer two kinds of stock options to employees: incentive stock options (ISOs) and non-qualified stock options (NSOs). The largest difference between these two categories of stock options is their tax qualification and eligibility requirements. ISOsISOs can only be given to workers who are classified as employees, either full-time or part-time. When an employee exercises an ISO, they do not have to pay taxes right away. Taxes on ISOs are paid when and if the employee decides to sell their shares at a later point in time. After the employee finalizes the sale, they pay capital gains and federal income tax to the IRS. To qualify for an ISO, the employee must hold onto their stock for at least a year after purchasing it and at least two years from initially being granted the stock options. A company’s board of directors also has to approve ISOs, verifying how many shares can be offered and who is eligible. ISOs have a time limit of ten years for employees who still work at the company, and 90 days beyond ending employment at a company. NSOsNSOs can be offered to anyone affiliated with your company, including independent contractors, investors and directors. If an employee disqualifies themselves from the terms of an ISO, their stock options are then treated as an NSO. Employers withhold tax on NSOs when employees exercise their options, and the difference between the excise price and the value of the stock is taxed as income. Frequently asked questions about stock optionsWhy do companies offer stock options?Companies offer stock options to employees as a way to make their compensation more lucrative and attractive to employees. Are stock options a business expense?Stock options are a business expense, and companies that offer stock options should keep track of them through stock option expensing. You can use a few different methods to calculate the expenses related to company stock options—the most common being the fair-value method. How are stock options paid out?After an employee exercises their stock options by purchasing company stock, they can sell those shares for a profit. They would contact a broker and fill out a trade ticket to exchange the stock for cash. |
What are stock options for employees
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