What are employee stock options?

Considered anemployee benefit, stock options grant workers the right to buy shares of the company at a set price after a certain period. Employees and employers agree ahead of time on how many shares they can purchase andthe vesting period before they can buy the stock. Once all parties are happy with the terms, this agreement typically becomes a contract that both parties sign.

Keep in mind that workersmust buythe stock before the vesting period ends or they lose their right to the employee stockoptions. Additionally, employees aren’t obligated to purchase company stock, even if they have stock options. Likewise, you may not have to offer stock options to every staff member. In fact, some companies offer ESOPs to only a few key positions.

Benefits of offering stock options to employees

Employee stock options give people theincentive to work with a company and invest in its growth. A cost-effective way to attract talented candidates, employee stock options often encourage new and old workers alike to stay for the long haul. These plans may also decreaseemployee turnoverrates to potentially save your business money in employment and training costs. Let’s look at these benefits in detail to showcase how they may benefitboth your business and employees, now and in the future.

The cost-effective part of employee stock options comes down to businesses not needing cash upfront to create a plan. Instead, business owners offer up the future value of their company’s equity instead of paying in the present. This buy-now-pay-later ethos proves especially popular for startups whose limited capital to pay employees requires them to get creative with compensation. Young businesses can provide potentially valuable stock shares at discounts rather than paying employees more salary or hourly wages.

Team members who own shares of stock have an additional financial incentive for performing well at work beyond their regular salary — as the company grows, so does their personal profit. This symbiotic benefit lays the foundation for success far beyond initial employment packages by tyingprofessional performance to potential gains. And, since stock options typically require employees to work with the company for a certain periodbefore receiving access, fewer people leave when they anticipate future profit.

Drawbacks of providingemployee stock options

Though many companies benefit greatly from offering employee stock options, risks and repercussions to these plans may make them unsuitable for your particular business. First, giving away equity in your company can dilute your ownership stake and limit your future profits.Additionally, less ownership and equity means you may not be able to attract investors to grow your business, should you need more cash.

Limited liquidity may mean employee stock options simply don’t do the trick when you’re seeking top talent. Employees can’t typically access the value of their options until after they’re vested and exercised. This may not be an attractive benefit when staff members have lower salaries and need the funds now. In some cases, they may even encounter restrictions onhow they may sell the stock. Other issues include drops in stock value and market limits for selling their shares.

Additionally, ESOPs remain tied to your company’s performance, so if your stock price declines, so does the benefit. Some workers may not understand the complex terms and vesting schedules involved, leading to misunderstandings over potential value and how their employeestock options work. Tax implications may also factor into downsides.

How do employee stock options work?

It’s important to ensure your team understands how employee stock options work. When you want to show stakeholders how these plans work, use this example of the entire employee stock options process to demonstrate how they function in a business.

Employee stock options example

Powercon Solutions hires Lee Wang as a manager during the startup phase. In her employment contract, the company includes terms that offer Lee the option to purchase 25,000 shares of Powercon Solutions stock at 15 cents for each share. The contract states that Lee’s stock options have a 4-year vesting period with a 1-year cliff.

What this means is that after working at Powercon Solutions for one year, Lee can access one-fourth of her shares. She then buys those 6,250 shares for $937.50, or 15 cents per share. The remaining 18,750 shares then vest at a consistent rate over the next 3 years. If, however, Lee leaves her position before the 1-year cliff, she can’t exercise her employee stock options at all.

After four years, Lee can purchase all remaining shares, and once she exercises and owns them, she likewise owns a small percentage of Powercon Solutions’s equity. While she can sell it to others at this point, holding onto the stock in anticipation ofcompany success leads Lee to wait. After another year, the stock rises to $10 per share. This means that the discounted shares she paid $3,750 for in total are now worth $250,000, giving Lee a $246,250 profit if she sells.

Types of employee stock options

Businesses can offer two kinds of stock options to employees: incentive stock options (ISOs) and non-qualified stock options (NSOs). The largest differences between these two categories of employee stock optionscomes down to their tax qualification and eligibility requirements.

ISOs

Only workers classified as full-time or part-time employees have eligibility to receive ISOs. These employee stock options require workers to hold the stock for at least a year after purchase and at least two years from the initial offering. When a team member exercises an ISO, they don’t have to pay taxes right away. Instead, the employee pays taxes when and if they decide to sell their shares at some later point in time. After the employee finalizes the share sale, they pay capital gains and federal income tax to the IRS.

NSOs

Businesses can offer NSOs to anyone affiliatedwith their companies,including independent contractors, investors and directors. If an employee disqualifies themselves from the terms of an ISO, their stock options get 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.

Offering employee stock options serves as a sound strategy when you wish to align your business’s interests with your workers’. By fostering a sense of ownership and commitment, employee stock options require little in upfront costs, providing lots of maneuvering room when you want to attract top-notch talent but can’t pay top-notch salaries. Navigating the complexities of these benefits, however, requires careful consideration and planning. By understanding the potential profit and pitfalls involved, you can contribute to your company’s long-term success and growth for yourself, your employees and other key stakeholders.

FAQs about employee stock options

Why do companies offer stock options?

Companies offer stock options to employees as a way to make compensation more lucrative and attractive.These benefits also help businesses create an ownership culture that fosters improved performance and long-term success.

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 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. To do this, they can transfer their shares to online brokerage accounts and place a sell order orcontact a broker and fill out a trade ticket to exchange the stock for cash.