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Smart Money

What To Know About Employee Stock Options

Employee stock options (also known as ESOs) are a common form of equity compensation, especially with startups and tech companies. By understanding how stock options work, you can make an informed decision about your benefits package and begin planning for your financial future.

Rachel Velez • May 11, 2022

In This Article

  1. What is an employee stock option?
  2. How employee stock options work: granting and vesting
  3. Types of employee stock options
  4. How to exercise employee stock options
  5. When to exercise employee stock options
  6. How are employee stock options taxed?
  7. The benefits of employee stock options
  8. FAQs
  9. Final thoughts: How to use employee stock options

Employee stock options (ESOs) are a type of equity that some companies offer as part of their compensation package for employees. A prospective employee may join a company with a lower salary in exchange for stock options that can earn them a lot of money later on. Sometimes they’re even offered just as an added benefit, in addition to a good salary, with no strings attached.

These benefit both you and the company you’re working for: When you own a piece of the business, it may motivate you to help it succeed. Sometimes employee stock options end up being more valuable than your salary, especially if you join a younger company early on and it ends up taking off.

Let’s take a look at how employee stock options work and go over the basics of their benefits and tax-related elements.

What is an employee stock option?

Employee stock options are the opportunity given to an employee of a public or private corporation to purchase shares of that company at a set price point. Employee stock options are considered a stock-based aspect of an overall compensation package offered to potential candidates. 

Companies will grant employee stock options to employees, which are governed under a legal agreement that gives the employee the right to purchase shares at a future date for a predetermined price called the exercise price. Their purpose is to give employees an incentive to work hard and contribute to the success of the company. 

They’re also commonly used to increase employee retention since they typically have a period of time tied to them — an employee usually has to stay at a company for a certain amount of time in order to earn their shares. Stock options can be a flexible investment that allows employees to make a profit or own part of the company where they work without a huge financial commitment.

How employee stock options work: granting and vesting

The value of employee stock options is based on the price of shares in comparison to the strike price. The strike price is usually the stock’s market price at the time an employer offers stock options to an employee. Sometimes this price is even discounted further to provide extra benefits to employees. While regular stocks can be regularly traded, employers set aside shares specifically for employees to purchase and create a limit on how much an individual employee can own.

Granting

Grants are how your company awards you employee stock options. You and the company will sign an agreement that documents the terms of the stock options, along with the grant date, which is the day your stock options begin vesting. This grant will give you all the details of your individual plan, including:

  • Type(s) of stock options
  • Amount of shares you’re awarded
  • Strike price 
  • Vesting schedule 

Vesting

The process of earning the right to exercise your options is called vesting. Fully vested stocks are options available for you to buy or exercise. Vesting periods also allow employers to optimistically rely on employees staying with their company for a certain period of time and eliminate the chance of new hires immediately selling their stock and leaving the company. 

A common vesting period is 4 years with a 1 year cliff, meaning that after 1 full year of employment, employees have access to a portion of their stock options. After that first year, they’ll be able to gradually earn more of their stock options through monthly or yearly increments until they’ve received the full amount of shares after the full vesting period (in this case, you would be fully vested after 4 years).

Types of employee stock options

There are 2 types of employee stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). The main difference between the two is how they’re taxed, as they have similar characteristics and terms.

Get a copy of your employee stock option plan (which will detail all the rules) to look through or hire an experienced financial advisor to help you.

Non-qualified stock options (NSOs)

A non-qualified stock option (NSO) is a form of employee stock option offered by employers where you pay normal income tax on the profit made once you exercise the shares. NSOs can be given to contractors and consultants and aren’t just for full-time employees.

NSOs are also offered and available to all levels of employment, not just executives. However, NSOs aren’t given preferential tax treatment. This is because they’re taxed as ordinary income tax, and you usually have to pay taxes both when you exercise and sell your options. 

Incentive stock options (ISOs)

Incentive stock options (ISOs), also referred to as qualified options, are employee stock options that are mainly offered to executive employees or upper management. ISOs are treated as long-term capital gains by the Internal Revenue Service (IRS) and are commonly seen in startup companies in their early stages.

How to exercise employee stock options

Following your vesting period, you can exercise your employee stock options right away or wait for the value to rise as a long-term investment. To exercise your stock options, it’ll cost you an amount that’s equal to the number of options multiplied by the exercise price. 

For example, if you have 5,000 stock options with an exercise price of $1, it will cost you $5,000 to exercise. Once this is done, your options turn into shares, and you own the stock, which you’re free to sell. You can also stay the course, anticipating that the stock price might increase.

When to exercise employee stock options

If you’re wondering when you should exercise your employee stock options, it will depend on a couple of different factors. If it’s not already, you may want to wait until your company goes public (hoping that it will). Your stocks could be worthless or near worthless if you pursue stock options and your company decides not to go public.

If your company does go public and has its initial public offering (IPO), you might want to wait for the stock price to rise above your exercise price.For example, if you have an exercise price of $5 per share and the market price is $3, it might not make sense to exercise your options just yet.

Lastly, it’s also important to know that your options have an expiration date, which you can find in your contract. It’s common for options to expire after 10 years from the grant date or 90 days after you leave the company. But, to make the best decision for your finances, you should consult with an investment professional for guidance.

How are employee stock options taxed?

If you exercise or sell your stock options, you’re most likely going to need to pay taxes on them. Your tax bill will depend on the type of stocks and how long you hold before selling. Here’s what the tax implications look like for each option:

 

Tax ImplicationsNon-qualified Stock Options (NSOs)Incentive Stock Options (ISOs)
Exercising Your Stock OptionsTaxed at the ordinary income rate and will go on your W-2 income. Required to pay the difference between the exercise price and the stock’s market value.Don’t have to pay taxes on the exercise date, but depending on the difference between the stock’s market value and the exercise price, the alternative minimum tax (AMT) may come into play.
Selling Your Stock OptionsRequired to pay short-term capital gains if you sell shares within 1 year of the exercise date. Also required if the shares’ long-term capital gains are sold after 1 year or more. Must pay taxes on the sale of ISOs. It’s listed as regular income if you sell your shares as soon as you exercise them. They fall under the long-term capital gains rates category if you hold the stock for a year or more and don’t sell your shares until at least 2 years after the grant date.

The benefits of employee stock options

Employees who are offered employee stock options can benefit from the company’s success — encouraging them to work hard and invest in the corporation’s goals and outcomes. Stock options can also attract top talent, especially when a company doesn’t have the ability to offer other competitive benefits and salaries. Offering stock options can also help businesses retain employees since they count on the long-term growth of their stock options. 

Overall, stock options can give employees a sense of ownership in the company, making them feel more connected to the company as a whole. For some companies, certain employees can receive stock options over several years throughout their careers. The payoff can be unlimited for companies that are continuously growing and advancing their stock prices.

FAQs

Should I accept employee stock options in exchange for a lower salary?

If you’re accepting a reasonable salary for your position and are offered employee stock options, it’s a good idea to take advantage of the opportunity. If you’re trading salary for stock, make sure you fully understand the business potential and future plans to ensure you’re making a sound investment.

What happens to employee stock when a company goes public?

This ultimately depends on the terms of your company’s acquisition when going public. When a company goes public, shares and options are often subject to a lock-up period, which is usually 90 to 180 days. During this time, employees can’t sell their shares or exercise stock options.

Once that period is over, you can choose to sell your vested stock options. In some cases, employees may want to hold on to stock, especially if they anticipate that the price will go up. Acquisition terms could accelerate or cancel options that aren’t vested.

Do companies offer other types of stock options?

Sometimes companies offer restricted stocks in addition to, or instead of, employee stock options. The two most common types are restricted stock units (RSUs) and restricted stock awards (RSAs). An RSU is when an employer agrees to provide shares of the company at a future date when specific criteria is met. An RSA is similar, except the shares can be purchased right away on the day that they’re granted.

Final thoughts: How to use employee stock options

Many employers are leveraging employee stock options as a benefit to attract talent and boost employee retention. They can be a great perk, but be sure to evaluate whether or not they’ll work for you and your investment goals.

For startups, keep that in mind when signing up for employee stock options.  Taking a smart approach to this benefit involves thinking about your financial future and figuring out the goals you have for your money. Once you understand what you’re hoping for financially, you can then figure out how employee stock options can play a role in your long-term financial well-being.

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