Employee Stock Options

What You Need to Know

Companies offer employee stock options (ESOs) to their employees and executives as a type of equity compensation. ESOs give the employee the right to buy company stock at a certain price. This right is for a certain period of time. With ESOs, the company does not grant the employee shares of the stock directly. If the company’s stock rises above the exercise price of the option, the employee will then be able to purchase company stock at a discount. If you are an employee who has been granted ESOs, a financial advisor can help assist you in determining the best course of action to maximize the benefits of your options.

What Are Employee Stock Options?

ESOs are part of an equity compensation plan that companies can offer employees as an employment benefit. These options give an employee the right to buy company stock at a specified price for a certain time period. There are typically two types of employee stock options. These include non-qualified stock options (NSOs) and incentive stock options (ISOs). There are some differences as to who is granted NSOs and ISOs, and a major difference between the two is how they are taxed. Employees with NSOs will pay ordinary income tax when the options are exercised and capital gains taxes when the shares are sold. Taxes on ISOs are paid only when the shares are sold. The tax paid on ISOs will either be ordinary income or capital gains depending on how long the shares are held.

How Do Employee Stock Options Work?

Once an employee is granted ESOs, there is usually a length of time an employee must wait to be able to exercise the options. This is known as the vesting period, and it will follow a pre-determined schedule set by the company. From the company’s standpoint, the vesting period provides incentive for the employee to perform and remain with the company.

Each company sets its own vesting schedule. For example, an employee may be granted the right to buy 500 shares of the company with the options vesting 25% per year over four years. Once the vesting period is met, the employee will be able to exercise the options. Companies will set a term of when the options need to be exercised. This is known as the expiration date. For example, if the term is 10 years, the ESOs must be exercised before that period is up.

Once the options vest, and the employee decides to exercise them, the employee can purchase the shares of company stock at the strike price in the options agreement. When the employee exercises the option, the spread, the difference between the exercise price and the market price, is generally taxed as ordinary income.

When the employee sells the stock, they will also face another taxable event. If the shares are held for longer than one year, the employee will pay taxes on the long-term capital gains. If the stock is held less than one year, the sale will be treated as short-term capital gains and will be taxed at ordinary income tax rates, which are generally higher than if the transaction was treated as a long-term capital gain.

Benefits of Employee Stock Options

ESOs provide several benefits for both the company and the employee:

ESOs can provide the employee with an opportunity to own shares of the company at a discount.
ESOs can provide the employee with additional compensation if the options are ultimately exercised above the grant price.
ESOs can allow employees to partake in the success of the business.
ESOs can provide the company with a valuable benefit to attract and retain talent.

Drawbacks of Employee Stock Options

There are some potential drawbacks associated with ESOs:

Since ESOs do offer the potential for additional compensation for employees, this compensation will ultimately be taxable.
There is no guarantee the price of the stock will increase over time, so there is the possibility the options will expire with no value to the employee.
Due to vesting schedules, the employee will have to remain at the company for a certain period of time to benefit from ESOs.

Is There an Employee Stock Options Tax?

Exercising the ESOs will trigger a taxable event, and the spread, the difference between the exercise price and the market price, will be taxed at ordinary income. When the employee sells the acquired stock, he or she will also be taxed. This will be treated as short-term capital gains or long-term capital gains depending on how long the stock was held.

Are Employee Stock Options Worth It?

ESOs are a great benefit for employees and can provide not only additional compensation but also an ownership stake in the company. The vesting schedules, expiration dates and tax consequences of ESOs can be complicated, so it is important to fully understand each to help ensure you make the most of your options. A financial advisor can be a valuable asset in helping you establish a strategy to get the most out of your ESOs.

FAQ

It is important to understand the grant date and vesting schedule of your stock options. Most likely, the options will vest over several years. For example, if you are granted 500 options that vest 25% per year over four years, you will be able to exercise 125 options after the first year, another 125 after the second year, etc.…

It is important to understand if you are granted NSOs or ISOs. Remember that with NSOs, the employee will pay ordinary income taxes when the options are exercised and capital gains taxes when the shares are sold. If you have ISOs, taxes will be due when the shares are sold.

Stock options have expiration dates. Companies usually set them at 10 years from the grant date, but it is critical to understand when your stock options expire. It would be unfortunate to forget or misunderstand the expiration deadline and lose out on a significant amount of compensation. Also, if you leave your company for any reason, make sure you understand if there is a time limit imposed for ex-employees to exercise vested options.

Timing the market and guessing what stock prices are going to do in the short-term can be very difficult if not impossible. Just because your options are “in-the-money” today doesn’t mean they will remain that way in the future. With vested options, the temptation is always there to wait to exercise for as long as possible on the chance the price of the stock will continue to rise. This can be a risky strategy, especially if the stock price takes a dive close to the expiration date. Holding onto the options can reap benefits but can also open you up to the risk your options will expire worthless.

Keeping all of your eggs in one basket is risky when investing, and while receiving ESOs is a great benefit, it is important to understand the importance of diversification in a portfolio. You don’t want too much of your wealth wrapped up in a single stock. As your options vest, it might make sense to diversify into other investments over time.

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