Employee Stock Options Explained: Why You Might Want to Bet on Your Employer (If You Can)

by Sarah Lybrand

A dollar bill

Employee stock options (ESOs) are a common form of equity compensation offered by companies to their employees and executives (the grantees). ESOs offer grantees the right to buy a specific number of shares of company stock at a specified price for a finite amount of time, usually ten years. 

Rather than grant shares of stock directly, the company gives derivatives on the stock in the form of regular call options. Often offered at a discount to the market value of shares, the grant price (also called the exercise price or strike price) is a specified price at which your ESO plan allows you to purchase the stock—whether you decide to or not. ESOs require no commitment or guarantee of purchase from the grantee, but simply remain ‘an option’ at any time, until they expire.

Unlike standard listed or exchange-traded options, ESOs are issued by the company and cannot be sold. They do not include any dividend earnings or voting rights. But – if a company’s stock rises above the exercise price — the stock could be “in the money,” (or worth more, sometimes even a lot more) when sold.

To see how much you’d stand to gain if you ever sold your options, track the difference between an ESO’s strike price and the fair market value (this is known as the bargain element). At that point, you can choose to sell the stock in the open market for a profit, or hold onto the stock to see if it increases in value. Of course, if the value of the stock falls below your strike price, the options aren’t worth anything, and it’s impossible to know what a stock price will do in the future.

Any company can offer stock options as part of its compensation package, but they’re often associated with fast-growing startup companies aiming to sweeten employee offers for key talent, as well as to reward early employees who worked hard to help grow the company’s value. In general, ESOs provide an incentive for employees to perform well and stay long-term to help the company succeed and eventually go public.

ESOs do come with restrictions. One such restriction is the vesting schedule, or the length of time that an employee must wait in order to exercise (or purchase) their stock options. Your vesting schedule begins on your grant date. ESOs typically vest in chunks over a few years, at predetermined dates chosen by the company. If an employee leaves before their options vest, they lose all value.

As an example, let’s say your ESO agreement grants you the right to buy 1,000 shares that vest 25% per year over four years. This means that you’d get the option to purchase 250 shares of the company’s stock at the strike price, one year from the grant date. Another 25% would vest two years from the grant date, and so on (fully vested after four years, and available as an option for ten). This ensures employees can’t make a quick exit for gain (by exercising their options, selling their shares for profit, and then leaving the company). But, for key hires or members of the C-suite, it could be possible to negotiate some of these terms: the rate of vesting for example, or a stock’s exercise price.

The tax burden on the stock depends on  whether the stock options are categorized as non-qualified stock options, or incentive stock options. This information and the rest of your ESO details appear in your ESO agreement. Drafted by a company’s board of directors, the ESO agreement should include a vesting schedule, shares represented by the grant, as well as your option strike price.

Consider discussing any ESO offer with a financial planner who can advise on how best to negotiate, exercise, and leverage ESOs (in terms of a long-range wealth plan), before signing on any dotted line. Since there’s no guarantee that ESOs will have any value at all, your overall financial plan should include investments in other diversified assets.

Employee stock options can be a valuable employee perk demonstrating a company’s commitment to both employee profit sharing—as well as future success. If the company fails, however, or the employee leaves before the options have vested, an ESO has no value at all.

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