Financial Lit: Employee Stock Options

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Many companies are now offering employee stock option plans (ESOs) as a way to recruit talented employees and provide incentive compensation.

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Here's how ESOs work and what they might mean for your salary.

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What Is an Employee Stock Option (ESO)?

An employee stock option plan gives the employee the right to purchase shares of stock in their employer's company at a specified price within a certain period of time. The company does not give stock directly to the employees, but instead, gives them a derivative option or the right to buy the stock at a discounted price.

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An employee stock option plan has the following parts:

  • Grant date​: This is the date the options are granted and begin to vest.
  • Vesting schedule:​ An employee must wait a certain period of time before being able to exercise their option and purchase company stock.
  • Strike price:​ The purchase price of the stock when the option is exercised is known as the strike price.
  • Expiration date:​ Employee stock option plans do not remain in effect indefinitely; they have expiration dates.
  • Exercise window:​ According to the vesting schedule, an employee has a certain window of time in which to exercise their option.

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Employee stock options only have value if the company's stock price goes above the option's strike price. Otherwise, you would simply let the options expire at their termination date.

How Do You Get Employee Stock Options?

An employer's stock option plan for employees can be included in an employee's contract or as a separate agreement.

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Why Do You Get Employee Stock Options?

Companies offer stock options plans as a form of compensation and as a way to motivate and reward their executives, managers and employees.

Companies can use stock options plans to attract talented employees that believe the company has a strong potential for future growth and success. In that case, employees might be willing to accept a lower salary in exchange for future gains in the company's share price.

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How Can You Use Employee Stock Options?

After an employee has become vested in the options plan, they can purchase the company's stock. However, employees may not always have the cash needed to exercise the option. In that case, an employee has two alternatives:

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Exercise the option and sell:​ The employee can use a brokerage firm that will use its funds to purchase the stock and then sell the shares on the open market. The brokerage firm will deduct the amount of its advance from the proceeds of the sale and give the difference to the employee.

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Exercise and hold:​ The brokerage firm will use its funds to buy the stock and then sell the shares needed to recoup the cash advance. The employee will continue to hold the remaining shares.

If an employee has enough cash to pay for the stock, they have two choices after exercising the option to buy the stock. The employee can either sell the stock immediately and realize the profit, or hold it if they believe the company will continue to be successful and the stock's value will increase in the future.

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What Are the Tax Implications?

The tax implications of a stock options plan depend on its type. The plan can be an incentive stock option (ISO) or a non-qualified or non-statutory stock option (NSO). An employee's eligibility for either type depends on the company's purpose for the plans.

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The IRS gives ISOs preferential tax treatment. With an ISO, you do not report any income until you sell the stock.

On the other hand, the profits from exercising your options in an NSO are taxed at ordinary income rates. You should have your tax advisor review your stock option plan to determine its type and tax consequences.

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