What are employee stock options?

ESOs let workers buy company shares at discounted prices after a certain employment length, or vesting period. Some vesting periods include a cliff, or the initial period that the employee must work before becoming vested. If the employee leaves their job before the cliff, they lose the stock options.

Employers determine how many shares employees can purchase and how long they need to work for the company before buying the stock. With an ESO, employees can buy the stock at the predetermined price, or strike price, regardless of the stock’s price at the time of purchase.

For example, you might offer an employee stock option plan (ESOP), allowing workers to buy 1,000 shares at a strike price of $10 per share. You might also specify that employees are only eligible after a one-year vesting period. If the share price rises to $50 during that year, employees can still get the $10 price.

In most agreements, workers need to buy the stock before the vesting period ends. However, employees may choose not to purchase company stock.

Benefits of offering stock options to employees

Stock options can have important benefits for your company:

• Incentive and motivation: Employee ownership ties professional performance to potential gains, which can help motivate employees and boost morale.
• Employee retention: Since stock options typically require employees to work with the company for a certain period before buying shares, it can encourage employees to stay with the company long term. Higher employee retention can potentially help your company save on hiring and training costs.
• Recruiting: Stock options can be a cost-effective addition to your recruiting strategy, making it easier to attract quality candidates. Instead of offering cash up front to create an ESOP, this compensation strategy offers the future value of your company’s equity.

Considerations when providing employee stock options

ESOs may not be right for every business. Before you decide to offer ESOPs, consider the potential drawbacks:

• Less equity: You may have an easier time attracting investors if you limit shared equity with employees, as you can offer shared ownership to them.
• Limited liquidity: Because employees can’t typically access the value of their options until after they’re vested and exercised (purchased), employees with limited cash reserves may prefer other benefits, such as a 401(k) match.
• Unpredictable benefit: Because ESOs are connected to your company’s performance, they may lose value if your stock price drops.
• Administrative burden: ESOPs typically involve administrative costs for managing plans, handling taxes, communicating with employees, selling shares and ensuring legal compliance.

Employee stock options example

Champion Solutions hires Nichelle Bernardo as a manager during the startup phase. In her employment contract, the company includes terms that offer Nichelle the option to purchase 25,000 shares of Champion Solutions stock at 15 cents per share. The contract states that Nichelle’s stock options have a four-year vesting period with a one–year cliff.

These terms mean that after working at Champion Solutions for one year, Nichelle can access one-fourth of her shares. She can buy 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 Nichelle leaves her position before the one-year cliff, she can’t exercise her ESOs.

After four years, Nichelle can purchase all remaining shares. Once she owns them, she owns a small percentage of Champion Solutions’ equity. While she can sell her shares to others at this point, Nichelle might keep the stock in anticipation of company success.

After another year, the stock rises to $10 per share. This means the discounted shares she paid $3,750 for are now worth $250,000. If Nichelle sells, she’ll make a profit of $246,250.

Types of employee stock options

Two types of ESOs exist: incentive stock options (ISOs) and non-qualified stock options (NSOs), which have different tax qualifications and eligibility requirements:

ISOs

Incentive stock options, or statutory stock options, are available to full-time or part-time employees. 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 sell their shares.

If they hold the stock for at least a year after purchase and at least two years from the initial offering, they’ll pay capital gains taxes on the sale. If this holding period isn’t met, the sale is subject to federal income tax.

NSOs

You might offer NSOs to anyone affiliated with your company, including independent contractors, investors and the board of directors. Additionally, if an employee doesn’t meet the terms of their ISO, their stock options get treated as an NSO.

NSOs have different tax treatments. You typically withhold tax on NSOs when employees exercise their options. Employees pay income taxes on the difference between the exercise price and the market price of the stock.

When employees sell their stock, they’ll pay capital gains taxes. If they hold the stock for more than a year, they pay long-term capital gains taxes. If they sell before then, they typically pay a higher short-term capital gains tax.

Stock options can give employees a sense of ownership and commitment while requiring minimal upfront costs. This may give you more flexibility to attract quality candidates.

Navigating the complexities of stock options requires careful consideration and planning. By understanding their potential, you can make an informed decision that supports your company’s long-term success.