Stock Options for Employees: ESO Explained

There are two main types of stock options, which are the standard exchange-traded stock option and the stock options for employees called the employee stock options (ESO). Over the course of employment, a company can issue stock options to employees. The ESO issued to employees can be exercised at a particular price that is set on the grant day.

What is a stock option? A stock option is a type of security that gives an investor the right to buy or sell the company’s shares at a set price before a fixed date. The set price of the stock is known as the grant price or exercise price and the fixed date of the stock option is known as the expiration date.

In this article, we will discuss how the stock options for employees work, their types, and their advantages and disadvantages. But first, let’s look at the basics of employee stock options.

See also: Types of stocks

It is important to note that holding an employee stock option doesn’t mean the employee owns shares in the company yet. It basically means that the employee has the right or choice (not obligation) to purchase the shares of the company at a specific price (grant price or exercise price) within a defined period of time (before the expiration date). The employee only owns stocks of the company when he/she decides to buy the company’s shares at the stated price and at the specified period of time. The process of buying the shares at the price and time specified by the stock option is known as exercising the stock options.

An employee may elect to exercise the options at some point depending on the vesting schedule and the maturity of the options. As requested, the company is obligated to sell its stock shares to the employee at whatever stock price that was used as the exercise price. At that point, the employee can decide to either sell public stock shares or hold on to them in the hope of further price appreciation. On the other hand, an employee can also decide not to buy the stock of the company as stated in the agreement of the options. In such scenarios, the options expire with no obligation to the employee.

Features of employee stock options

• Exercise price
• Quantity
• Vesting
• Liquidity
• Duration (Expiration)
• Non-transferable
• Over the counter

The features listed above are some of the characteristics of the stock options for employees that make them different from standard exchange-traded options.

Exercise price

One of the features of stock options for employees is the exercise price or grant price. This is the set price of the stock which is the current price of the company stock at the time that the option is issued. The exercise price is non-standardized. Alternatively, a formula can be used to determine the exercise price which involves sampling the lowest closing price of the stock over a 30-day window on either side of the grant date.

On the other hand, the exercise price chosen at the grant date should equal the average price for the next sixty days after the grant. This would eliminate the chance of backdating and spring loading. Usually, an employee may have employee stock options exercisable at different times and at different grant prices.

Quantity

Compared to the standardized exchange-traded options, the quantity of ESOs is non-standardized. Standardized stock options usually have 100 shares per contract while employee stock options usually have some non-standardized amount.

Vesting

The stock options vesting period is the timeframe during which an employee can earn the options. This means that the employee doesn’t get to own all the options granted to him in the grant letter at once. Rather he earns them over a period of time. For instance, if Y number of shares were granted to the employee initially, then all the Y shares may not be in the employee account.

More so, some or all of the options may require a certain event to occur, such as a change of control of the company or an initial public offering of the stock. Also, all or some of the options may require that the employee continue to work in the company for a particular term of years before selling or transferring the stock/options. The company’s intention is to entice the employee and keep him working for the company as long as possible. Therefore, the options vesting serves as a lure; more option is earned, as the number of years increases.

The company usually set the timelines known as the vesting schedule. This vesting schedule tells the employee the dates and number of years it will take him to work with the company to be able to earn the option. For instance, the vesting schedule can indicate that it will take an employee 5 years with the company to be able to earn 2000 options.

Furthermore, companies usually use targets to set vesting schedules. Therefore, the vesting schedule may change depending on the employee or the company meeting certain performance goals or profits. It could be time-based targets, milestone achievements, or a combination of both.

The milestones could be based on the employee’s performance while others could be based on the company achieving a milestone. As far as milestones can be achieved on time, employees have the opportunity to quickly earn options from milestone-based vesting. This gives an employee control compared to time-based vesting where he or she has to stay with the company for the required number of years.

For instance, a firm may give a sales executive (an employee) a target of $3 million in sales to earn 1,000 options. The faster the sales executive achieves this milestone, the earlier the 1,000 options are vested (earned) compared to time-based vesting which would require the sales executive to work for years to earn the same options. However, it is possible for some options to time-vest but not performance-vest. This can cause an unclear legal situation about the value of options and the status of vesting.

Liquidity

Usually, the employee stock options for private companies are not traditionally liquid, because they are not publicly traded. The liquidity of stocks is usually judged by the daily trading volume of the stocks, whereas options are not necessarily traded as heavily as stocks. As a matter of fact, there can be 100s of different contracts for options available on the market. When options are far away from their expiration dates, they can be illiquid.

Duration (Expiration)

The stock options for employees usually have a maximum maturity that far exceeds the maturity of standardized options. It is common for ESOs to have a maximum maturity of 10 years from the issued date, whereas standardized options often have a maximum maturity of about 30 months. However, if the holder of the ESOs leaves the company, it is common for this expiration date to be moved up to 90 days.

Non-transferable

The stock options for employees are generally not transferable though there are few exceptions. ESOs must either be exercised or allowed to expire worthless on the expiration day. Therefore, there is a substantial risk that when the stock options for employees are granted, they will be worthless at expiration. This should encourage the holders to reduce the risk by selling exchange-traded call options. As a matter of fact, it is the only efficient way to manage speculative SARs (stock appreciation rights) and ESOs. Generally, it is advisable to early exercise ESOs and SARs, then sell and diversify.

Over the counter

Unlike exchange-traded options, the stock options for employees are considered a private contract between the employee and employer. As such, any transactions that result from the contract are arranged to be cleared and settled by the two parties. More so, the employee is subjected to the credit risk of the company. The employee may have limited recourse if the company for any reason is unable to deliver the stock against the option contract upon exercise. But for exchange-traded options, the Options Clearing Corp guarantees the fulfillment of the option contract.

Types of stock options for employees

1. Incentive stock options (ISOs)
2. Nonqualified stock options (NSOs)

There are two main types of employee stock options such as incentive stock options, or ISOs, and nonqualified stock options, NSOs. The distinction between these two has a big impact on the tax treatment, which may in turn affect the strategy employed with the options.

Incentive stock options (ISOs)

Incentive stock options (ISOs) are also called qualified or statutory options. This type of ESO is generally only offered to top management and key employees. In many cases, they receive preferential tax treatment because the IRS treats gains on such options as long-term capital gains.

The incentive stock option gains aren’t taxed as ordinary income at the time of exercise, though an exception is when the ISO holder sells the stock at the same time. There’s rather a tax benefit to holding the stock after exercising in order to qualify for the lower long-term capital gains rate on the profits from the sale. However, the employee must meet two criteria in order to qualify for the lower long-term capital gains. First, the employee must have held the options for more than two years beyond the grant date. Secondly, the employee must hold the stock for more than one year after exercise.

Furthermore, the alternative minimum tax (AMT), can come into play with incentive stock options. However, due to changes in the tax code that went into effect in 2017, it’s less likely that taxpayers who exercise ISOs will pay AMT. This was not the case five years ago. Under ISO treatment in the AMT system, the difference between the grant price and the shares’ value at the time the options are exercised (but not sold) is taxable as income. Though this is not the case with the regular tax system.

Nonqualified stock options (NSOs)

Non-qualified stock options (NSOs) are also called non-statutory stock options. This type of ESO can be granted to employees at all levels of a company, as well as to consultants and board members. The profits on these employee stock options are considered ordinary income and are taxed as such.

At the time of exercise, the non-qualified stock options are taxed at the investor’s ordinary income tax rate. From a practical point of view, it’s common for employees with options to elect a cashless exercise, which entails selling enough shares at the time of exercise in order to cover the cost of the shares and the related tax bill. In such cases, the employee comes out with fewer shares. The benefit, however, is that the employee will not have to front the cash needed to exercise the options.

Taxes for stock options: NSO and ISO

There is a variety of differences in the tax treatment of employee stock options relating to their use as compensation. These vary depending on the country of issue. However, in general, the stock options for employees are tax-advantaged with respect to standardized options.

In the United States, the stock options for employees are of two forms which differ primarily in their tax treatment. They could be either incentive stock options (ISOs) or non-qualified stock options (NQSOs or NSOs).

In the UK, on the other hand, there are several approved tax and employee share schemes such as Enterprise Management Incentives (EMIs). The employee share schemes that the UK government doesn’t approve of don’t have the same tax advantages.

Related: Treasury stocks

Employee Stock Options Explained

The stock options for employees are typically granted by the company’s board of directors and can be exercised at any time before their expiration. Usually, the stock options for employees are issued by the company and cannot be sold, unlike exchange-traded or standard listed options. The options can be granted to former or current partners, employees, or members of the company’s advisory board.

There are two types of ESO grants which include time-based grants and performance-based grants. The former allows employees to earn a fixed number of shares at specified dates whereas, the latter allows employees to receive shares based on their company’s performance.

An employee has the opportunity to exercise the stock option grant received at a later date at a predetermined price. The option grant may vest over a period of time or vest all at once. Vesting may be granted all at once known as cliff vesting or can be granted over a period of time known as graded vesting. Be it cliff vesting or graded vesting, it can be uniform or non-uniform. For example, the vesting is said to be uniform when 20% of the options vest each year for 5 years. Whereas, in a case that 20%, 30% and 50% of the options vest each year for the next three years, it is said to be non-uniform.

As with restricted stock, the employer grants options to employees to motivate them to stick around until they can exercise their stock options. Ten years is the most common length of time between an options grant and the exercise window (i.e the time frame during which the employee can exercise the options and buy the stock). The employee stock option doesn’t include any dividend or voting rights. It is just a right granted to employees to motivate them in giving in their best to a company.

ESOs are a benefit usually associated with startup companies. Such companies issue stock options to employees in order to reward early employees when and if the company goes public. Also, ESOs are awarded by some fast-growing companies. They issue these stock options as an incentive for employees to work towards growing the value of the company’s shares. The ESO can also serve as an incentive for an employee to stay with the company which is canceled if the employee leaves the company before he vests.

Generally, stock options are beneficial if the stock price of the company rises above the exercise price. Call options are exercised when the price of a stock rises above the call option exercise price. So, the holder of the call options obtains the company’s stock at a discount. The holder can choose to sell the stock immediately in the open market for a profit or hold onto the stock over time. In addition, employee stock options usually have tax advantages, allowing employees to reduce their tax liability as they hold onto their shares.

How to calculate stock options for employees

Calculating the value of stock options for employees can be tricky because the value is affected by factors like volatility, strike price, time to expiration, the risk-free rate of interest, and the underlying stock price. Understanding the interplay of these variables is crucial for calculating the value of ESO and making informed decisions.

The stock option benefit is calculated as the difference between the exercise price and the fair market value of the shares at the date of exercise. Unfortunately, an employee can’t be 100 percent sure how much money he or she will make from their options because the value is uncertain. The higher the company’s exit value (i.e the value the company is expected to be sold for), the more valuable the options will likely be.

Let’s look at an example to have a better understanding of employee stock options.

An example of how ESO works

Assuming Mr. Peter received 100 shares of his employer stock in 2013, with a strike price of $10 per share when the stock was trading at $3.5 per share. The ESO had an expiration date of Dec. 31, 2021.

Supposing towards the end of 2021, the stock was trading at $20 per share when Mr. Peter wanted to exercise his options. It is said that the options would be in the money. ‘In the money’ is when the fair market value of stocks is greater than the grant price of the option. This means that the strike price is below the stock price at the time of exercise which is an opportunity for Mr. Peter to make a profit.

His profit would be the difference between the $2,000 (i.e the shares’ value at the time of exercise) and his $1,000 exercise price (i.e his 100 stock options multiplied by the $10 strike price). Mr. Peter can choose to either sell the shares and pocket his $1000 profit or hold on to the shares after exercising in the hope that the share price would go higher.

However, it is important to note that not all stock option grants yield a profit. For instance, if Mr. Peter received 100 shares of his employer’s stock with a strike price of $10 per share but the price per share of the stock stayed between $6 to $8 during his exercise window, then his options are said to be out of the money. ‘Out of the money’ or ‘underwater’ is when the market value of stocks is less than the grant price. In such an instance, Mr. Peter will be better off letting the options expire as it is obvious, that he won’t make a profit.

Related: Differences between stocks and shares

Stock options offer employees an opportunity to have ownership of the company they work for. This can make them feel more connected to the business and to their co-workers. An employee holding a stock option means he can reap some of the financial rewards of the business when successful. This increases dedication for all employees involved, as they are more invested in growing the company to yield positive results.

By purchasing the company stock, employees exercise their stock options. After this, they can sell the shares for a profit. ESOs can offer some tax benefits and allow employees to invest without paying broker’s fees. It can also serve as a sound investment for someone with a long-term financial strategy.

In the United States, employee stock options are one of the most common forms of compensation that employees receive. Restricted Stock Units (RSU), Phantom Stock, Stock Appreciation Rights (SARs), and Employee Stock Purchase Plans are examples of other compensation plans for employees.

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Advantages of stock options for employees

Employee stock options are cost-effective company benefits that can help make employment packages very attractive. From a human resources perspective, companies use ESOs to increase staff retention. For instance, the vesting of stock options requires employees to remain employed for a certain period of time before the shares can be issued and sold.

Many companies use ESOs to give employees an incentive to behave in ways that will boost the company’s stock price. The employee, on the other hand, can benefit from exercising the option where he pays the exercise price and gets issued common stock (ordinary shares) in the company. Therefore, experiencing a direct financial benefit from the difference between the stock market price and exercise prices.

Another benefit of issuing employee stock options as compensation is that the company can preserve and generate cash flow. There is cash flow when the company issues new shares and receives the exercise price, getting a tax deduction equal to the ESOs’ intrinsic value when exercised.

Also, stock options offer employees an opportunity to have ownership of the company they work for. This can make them feel more connected to the business and to their co-workers. An employee holding a stock option means he can reap some of the financial rewards of the business when successful. This increases dedication for all employees involved, as they are more invested in growing the company to yield positive results.

Disadvantages

In as much as employee stock options can be advantageous to the company and employees, there are some risks and repercussions of issuing these stock options. One repercussion is the dilution of ownership.

Giving away equity in a company through stocks can dilute the ownership of the business and limit future profits if the company becomes successful. Dilution of ownership of a business can be very costly to shareholders over the long run. More so, the less ownership one has, the less equity one has to offer to investors for the growth of the business.

One of the disadvantages of stock options for employees is the tax implications. This can be complicated for employees. Also, stock options are difficult to value and in some cases, the employee must rely on the collective output of management and their co-workers in order to receive a bonus.

In addition, one of the major disadvantages of stock options for employees is that the employee is subjected to the credit risk of the company. The employee may have limited recourse if the company for any reason is unable to deliver the stock against the option contract upon exercise.