Employee Stock Options: What They Are and How They Work for Employers

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.

 

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What are stock options?

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 employees

Stock 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 options

There 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 options

You 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.

 

ISOs

ISOs 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. 

 

NSOs

NSOs 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 options

 

Why 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.

 

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