What is an employee stock option?
An employee stock option(ESO) is a contract that a corporation (granter) issues to an employee (grantee) that gives them the right to purchase a set amount of shares at a predetermined price (known as the strike price) within a specific time window. The employee can exercise the contract whenever they see fit within that time window, thereby triggering a purchase of the underlying security at the agreed-upon price, regardless of the current market price.
Selling the shares
The employee (grantee) then turns around and sells the shares at market price. The profit is the difference in price between the option contract’s price and the market’s current price of the underlying asset – after subtracting fees, taxes, and bid/ask spreads.
For example:
Company XYZ gives James 100 stock options. The options allow James to purchase the shares for $10 each. When the company provided James with the options, the share price was $9. It doesn’t make sense for James to exercise those options and purchase them at $10 a share if they are only worth $9.
So James waits until the shares are worth $20. He exercises the options, purchases 100 shares at $10 each, and instantly sells them for $20 each for a profit of around $1,000.
If Company XYZ issues James his options in 2019, we can see from the above graph that it only becomes profitable to exercise them at some point after 2020. If James exercises them when shares are worth $20, he stands to profit $1,000. By waiting, he could even make more. But, they expire in 2023, so he has to make a decision before then. He even runs the risk of them going back down in price.
Strike Price and Expiration Date
Options have an expiration date, meaning you must exercise them before that date. If you don’t, they expire worthless, even if they are “in the money.” It’s doubtful an employee would allow their options (their incentive bonus) to expire if they are in the money, but there is a very real risk of the options expiring worthless by never rising above the strike price – or diving down below the strike price and remaining there, as shown in the two examples above. As we can see in Chart B, James should have exercised in 2022, but decided to hold until the last minute, with unfortunate results.
Why do companies issue Employee Stock Options?
The ESOs (employee stock options) serve as an incentive for James to work extra hard. It puts the amount of his bonus into his own hands, with the sky as the limit. The logic is as follows – the more diligently James and his fellow employees with stock options work, the greater the chance the stock will rise above the strike price.
In theory, the stock price could rise to $1,000 – or $10,000, making any option owners very wealthy, which is one reason why ESOs are very popular amongst startups and tech companies. Many of us have heard rags-to-riches stories due to ESOs. One famous example is Facebook graffiti artist David Chloe, who ended up with $200,000,000(!) of stock options when Facebook went public.
ESOs are Bullish
James’ scenario explains a vanilla “call” option, which is bullish in nature (meaning, the hope is that the value of the underlying security will increase – this is in contrast to a bearish “put” option). A company may even reward “in the money” ESOs for achieving a Key Performance Indicator.
But not all ESOs are as simple as James’ situation above. Many companies offer a variety of ESOs with different restrictions and rules. Here’s a quick run-through of the most common ones.
Kinds of Employee Stock Options
Incentive Stock Options
These are the ESOs you hear about when the CEO of XYZ receives a large block of stock options as part of their remuneration package. Companies offer these kinds of ESOs to key employees and executives to retain their talent and incentivize performance. They may also be used as a part of a talent acquisition strategy.
ISO Vesting
The usual vesting time is two years, after which the grantee must wait one year to sell the stocks received upon exercising the options. Here we see a downside of ISOs. Should the stock drop below the strike price, the grantee can end up losing money. It should also be noted that the grantee MUST exercise their ISOs within ten years.
Incentive Stock Options are tax-advantaged, meaning that recipients of these options only have to pay relatively low capital gains taxes as opposed to regular income taxes, which are much higher. The grantee must hold the stocks for one year to qualify for capital gains tax.
Non-qualified Stock Options
These are for all other employees, board members, and consultants. They do not possess the tax advantages of Incentive Stock Options. Similar to ISOs, they may also come with caveats, such as vesting, limiting the grantee’s ability to exercise the option.
Non-qualified stock options are particularly popular with young companies that don’t have the funds to pay large salaries, so instead, they offer ESOs to make up for it. Unlike an ISO, the bearer of the options is not constrained by a holding period. This means that, after any existing vesting period, the grantee can exercise their options without further delay.
Employee Stock Option Alternatives
There are other ways to tie performance and loyalty to a company’s stock without utilizing ESOs. Some examples are Restricted Stock Units (RSUs), Phantom Stock, and Employee Stock Purchasing Plans. Stay tuned for an article explaining how they differentiate from standard Employee Stock Options.
Employee Stock Option Plans in Labor Contracts
When you start a new job, all ESOs they grant you must be clearly stated, including the precise conditions. Conditions include strike prices (often the current price of the shares if already publicly traded), vesting periods, holding times, and exercise methods. When to exercise your options and how the government will tax them is beyond the scope of this article. However, stay tuned for individual pieces on those exact subjects.
Employee Stock Option Vesting Schedules
The vesting schedule of an employee stock option plan states how many options per year an employee will get. For example, James has a five-year contract with Company XYZ. In this contract, XYZ states he will receive 400 ESOs by the end of the 5th year of his employment.
In his second year working there, he gets 100 stock options, meaning he is 25% vested. If they are non-qualified options, he can exercise them straight away if they are in the money. Alternatively, he can hope the stock price will go up and hold them. The following year, he gets another 100 options. This process continues for another four years, after which he will be 100% vested.
Key Performance Indicators
The vesting schedule can also be connected with Key Performance Indicators. These are referred to as Performance Stock Options. The company will reward James if the Total Return on Capital is over $10,000,000 – as an example. James does well for himself when the company prospers and misses out on bonuses when business is lousy. It would behoove James and any other grantees of Performance Stock Options to improve the bottom line.
In Conclusion
Employee Stock Options are a great tool to retain and attract top talent. They also incentivize employees to perform effectively. After all, it is in their best interest for a company to grow and thrive.
Has your company issued you ESOs? Make an appointment today with a Sarasota financial advisor to better understand your tax obligations, how they fit into your overall investment portfolio, and the optimal time to exercise them.
