Employee Stock Options Explained

Employee stock options (ESO) are one form of compensation corporations give to executives and senior employees. Unlike salary or bonuses, the value of a stock option depends on the price of the company's stock going up. The idea is that a stock option thus serves as an incentive to the employees to work hard to ensure the company performs well. Employee stock options can be worth tens or hundreds of thousands of dollars--even millions.



An employee stock option functions much like the call option contracts traded on options exchanges. An ESO gives the holder the right to buy shares of the company stock at a stated price called the "strike price." Usually, the company requires the employee to wait a minimum holding time before she may exercise the option after it is issued. From then until the expiration date, the employee can exercise the option at any time. If company stock appreciates, the employee can use the option to buy shares at the lower strike price and then resell them at the market price, keeping the difference.


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There are two basic kinds of employee stock options. Statutory options (also called "qualified" or "incentive options") allow the holder to get capital gains tax rates on profits derived from exercising the option, provided certain rules are followed. Non-qualified or non-statutory options cannot get this tax break, but they allow more flexibility for the option holder in other respects.


Statutory Options

Under U.S. Securities and Exchange Commission regulations, a statutory stock option can only be issued with a strike price at or above the market price of the stock at the time of issue. The recipient has to have been employed by the company for at least 1 year and may not exercise the option for at least 1 year after it is issued. In order for profit from the option to qualify for capital gains tax rates, the employee must hold the shares after buying them for at least 1 additional year after exercising the option. Provided these rules are followed, all profit (defined as the difference between the strike price and the sale price) is taxed at the capital gains rate, rather than as regular income.


Non-Statutory Options

Regular (non-statutory) employee stock options may not qualify for capital gains, so there are no special restrictions on the exercise procedure. In general, they are exercised much as are traded options once any company-mandated waiting period is complete. The easiest way to do this is through what is called a "cashless exercise," which avoids the necessity to come up with the funds required to pay the strike price. To execute the cashless option, the holder takes the options to her broker. The broker will advance the funds to buy the stock (for a small fee) and sell the shares at the market price. The option holder thus collects the option profits without having to pay the strike price in cash.


Reload Options

Some non-qualified stock options have a "reload" provision in the contract. Suppose you have an employee stock option for shares with a strike price of $20 and the market price is now $30/share, but the option does not expire for another year or so. You can exercise the option and avoid the chance the stock might decline, or you can hold the option in hopes the stock will appreciate further. With a reload, you get to do both. When a reload option is exercised, the company issues a new option with the same expiration date, but with the current market price as the new strike price. You can secure gains made to date and still collect the profit from any future increases in the stock's value by exercising the reloaded option again later on.


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