What Is An Employee Stock Option? Types Explained

Stock options generally allow companies to buy a piece of the company at a discounted rate in exchange for the dedication and commitment that they provide.

Being a small business, you can consider offering stock options as a good way to compensate employees.

Terms and conditions for employee stock options would be spelled out to the employee in a given agreement.

Corporate benefits for some or even all employees might include equity compensation plans. The first of these plans provide financial compensation in stock equity form.

Under this guide, you can learn about employee stock options and how they work.

What Is An Employee Stock Option?

Generally, the best part about a stock option is realized if the company’s stock goes beyond the current price. Typically, these stocks are issued by the company and cannot be sold like standard or exchange-traded stocks.

Call options can be exercised At a discount when the stock prices go beyond the exercise option price. The holder has all the rights to choose the stock immediately when the open market for the given profit or hold the stock for a given time.

Employee stock option is just one type of equity compensation that the company would offer other types of equities are given below.

Restricted Stock Grants

These allow the employees to acquire some shares once given criteria are attained, including working for defined years and meeting the performance targets.

Stock Appreciation Rights

These rights provide the right to enhance the value of the designated number of shares, like an increase in the value, which would be payable in cash or the company stock.

Phantom Stock

This space is the future cash bonus equivalent to the value of defined shares. No legal transfer of the ownership of shares takes place even though the phantom stock might be convertible to the actual shares if the events trigger.

Employee Stock Purchase Plans

These plans give the employees all the right to purchase company shares, and they, too, are at a discounted rate.

For employees, the major benefits of equity compensation plans are mentioned here:

There’s an opportunity to share the company’s success directly through the stockholdings.

There is also a pride of ownership where employees might be completely motivated to be productive because they have a stake in the company.

There is also a tangible representation of how much the contribution is worth to the employer.

Depending on the given plan, it might offer the potential for tax savings after the sale or share disposal.

The benefits of an equity compensation plan for employers are mentioned here:

It helps improve employees’ job satisfaction and financial well-being by providing great financial incentives.

Incentivizes employees to help the company succeed and grow as they can share in the success.

It might be a great withdrawal plan for all the owners.

Different Types Of Employee Stock Options

Incentive Stock Options

They are also known as statutory or even qualified options, which are only offered to some employees or top management.

In most cases, they receive some tax increment as the IRS will treat gains on such options as long-term capital gain.

Non-Qualified Stock Options

They would be granted to all the employees no matter the company level they are at. They are also given to the board members besides consultants.

Some of The Important Concepts You Need To Know About

There are mainly two parties in the employee stock options: the grantee and the grantor. A grantee is also an option, while the grantor would be the company that employs that grantee.

The grantee would be given equity compensation in the form of employee stock options which generally have some restrictions, one of the most important of which includes a vesting period.

The vesting term is the length of time the employee should be waiting to exercise the employee stock options.

It is because it incentivizes the employee to perform well and start with the organization. Vesting also has a predetermined schedule which the company sets up at the option grant.

Vesting

Employee stock options are vested when the employee can exercise all the options and purchase the company’s stocks.

The stock might not be completely wasted when purchased with an option in only some areas despite exercising the stock options as the company might not want to run the given risk of employees making a quick gain by exercising the options and immediately selling the shares and leaving the company.

If you have any options granted, you need to go through them completely and determine the rights available besides the restrictions applicable to the employees.

The company’s board of directors drafts the stock options plan, and it features all the details of the rights of the grantee.

At the same time, the options will provide the key details, like the vesting schedule, how the employee stock options would W the shares represented by the grant and the strike price.

If you are one of the major employees or executives, it would be possible to negotiate Some elements of the options agreement, like the vesting schedule where the shares vest quickly or a low exercise price is given. Understanding the options agreement with the planner or wealth manager might also be important before you sign on any dotted line.

Receiving the Stock

It should be focused on that the record price for all the shares is the strike price given in the options agreement, no matter the actual price of the stock in the market.

Employee Stock Options And Taxations

The triggers available at a tax event apply to all the spreads, and some are mentioned here.

The option grant is not a taxable event. As such, the grantee or the options would not be faced with any tax liability instantly when the company grants the options. You need to know that the exercise price of the stock would be set at the given market price of the company’s stock on the option grant day.

The taxation will start at the time of exercising the spread. The spread is also prominently known as the bargain part of the tax parallels and is taxed at standard income rates. It is because the IRS considers it part of the employee’s compensation.

The sale of the acquired stock will trigger another event. It can also qualify for a lower capital gains tax rate if the acquired shares are sold after one year.

Intrinsic Value Versus Time Value For Employee Stock Options

The option value includes intrinsic value and time value. The value will depend on the amount of time that remains till expiration and other variables considering the majority of the employee stock options have a stated expiry date of around ten years from the option grant date the time value will be used.

While time value can be calculated easily for the exchange-traded options, it is challenging to calculate the time value for any non-traded options, including the employee stock options, as the market price is not easily available to calculate the given time value.

For the options, you need to use a theoretical pricing model, including the black Scholes option pricing model, to compute the complete value of the Employee stock option.

It would be best to put inputs like the time remaining exercise price and risk-free interest stock price volatility in this model to get a fair value estimate of the stock.

The exercise of the ESO would help in capturing your perfect intrinsic value, and it will also give you the time value.

In short, you need to know that the value of this stock is not static; instead, it will keep on fluctuating with time, and it all depends on the movements of various inputs like the price of the given stop expiration time and the volatility plays a crucial role.

Employee Stock Options Versus The Listed Options

One of the major differences between the listed option and employee stock options is that they are not traded on any exchange. It means that it does not have several benefits of exchange-traded options.

The Value Of The Employee Stock Option Is Not Easy To Get

Exchange-traded options, especially some of the biggest stocks, have a huge liquidity deal and trade frequently.

So it is very easy to estimate the value of the portfolio of options. It is not the case with employee stock options, whose value is not as easy to estimate.

Several employee stock options would be granted with a given term of 10 years or even more, but they have not listed that trade virtually for that time.

Option pricing models are very important for understanding the value of employee stock options. The employer would be required to get the options on the given grant date to specify a theoretical price of the employee stock options.

You must ensure to request the information from the company and determine how the value of the stock options is determined.

Option prices are likely to vary to a great extent. It all depends on the assumptions which are made in the input variables.

For instance, the employer might make some assumptions about the expected employment length and estimated holding time before exercise, which could shorten the time so the given expiration.

Assumptions about volatility also have a huge impact on option prices.

Key Takeaways

Employee stock options are contracts between employers and employees that allow employees to purchase shares of their company’s stock at a predetermined price.

Two main types of employee stock options exist incentive stock options (ISOs) and non-qualified stock options (NQSOs).

ISOs have special tax advantages but are subject to more stringent rules and restrictions than NQSOs.

Employee stock options can be a valuable form of compensation for employees, but they also come with risks and potential tax implications.

Employees should be aware of the vesting requirements and any restrictions on the sale of the stock, as well as the potential tax implications of exercising the options.

To make the most of their stock options, employees should consider their own financial goals and risk tolerance and seek professional advice if needed.

Companies can use employee stock options as a way to attract and retain talented employees and to align employees’ interests with those of the company.

Conclusion

Employee stock options are equity compensation that companies grant to employees and executives. Just like the regular call option, these options give the holder all the rights to purchase assets that are the company’s stock at a specific price for a given time.

They are not only that type of equity compensation but also among the most common ones.

Stop options are available in two types of incentive stock options which generally are offered only to some employees, and top management gets preferential tax treatment.

So employee stock options should be familiar with all the stock options of the company and the options agreement to understand any restrictions and clauses given.

FAQs

Why do companies offer employee stock options?

Companies offer stock options to attract and retain talented employees, align employees’ interests with those of the company, and provide an additional form of compensation.

What are the different types of employee stock options?

The two main types of employee stock options are incentive stock options (ISOs) and non-qualified stock options (NQSOs).

Other less common types include restricted stock units (RSUs) and employee stock purchase plans (ESPPs).

What are the differences between ISOs and NQSOs?

ISOs have special tax advantages and are subject to more stringent rules and restrictions than NQSOs.

For example, ISOs can only be granted to employees, must be exercised within a certain time frame, and have a maximum value limit.

How do employee stock options work?

Once an employee is granted stock options, they typically need to meet certain vesting requirements before they can exercise the options and purchase the stock.

Once the options are exercised, the employee can either hold onto the stock or sell it for a profit.

What are the tax implications of employee stock options?

The tax implications of employee stock options depend on the type of options and when they are exercised.

ISOs have special tax advantages, but there are certain rules that must be followed to take advantage of them.

What risks should employees be aware of when considering stock options?

Employees should be aware that stock options are subject to market fluctuations and that the value of the stock may go down as well as up.

They should also be aware of any restrictions on the sale of the stock, and the potential tax implications of exercising the options.