Terms of an ESO are spelled out in an employee stock options agreement, which is a legal agreement that essentially binds an employee’s bonus to the company's future growth.
Employee stock options, or ESO, is a type of stock-based compensation an employer can offer its employees and other key personnel as incentives or bonus pay.
ESOs are not direct shares of stock. However, they are call options that grant the employee the right to purchase shares of private companies’ stock at a pre-determined price for a given amount of time.
ESOs are often associated with startups that use them as an incentive to join the company on the ground floor. Additionally, companies experiencing rapid growth could issue stock options as incentives for existing employees to stay and help grow the company's value.
Keep in mind, however, that ESOs do not include voting rights or rights to dividends. If the employee leaves the company before they vest, they are canceled.
Now that we’ve covered the basics let’s review 8 important things to look for in an employee stock options agreement.
1. Number of Shares
The number of shares is important because it sets the agreement's value per se. Depending on how it is structured, it limits what shares an employee can purchase in the future.
Considering that the price of shares fluctuates based on the company's value, you want to ensure you understand this section before signing a binding employment contract.
Here is an article about exercising your share rights.
2. Exercise Price
When given an offer letter outlining details about the ESO agreement, it should include the exercise price. This is the pre-determined price offered to the employee at the time of the agreement.
The exercise price should come in at a fair market value of the shares when they are offered. This will also set the price at which shares in the future can be purchased.
Here is an article about how to calculate aggregate exercise price.
3. Grant Date
The grant date of an employee stock option agreement is when the issuing company issues the employee stock options.
As we noted in the exercise price, the grant date is essential to the overall agreement. Therefore, the exercise price is based on the date the shares are granted, and the expiration date is also based on this date.
Here is an article about understanding your employee stock options.
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4. Vesting Schedule
A vesting schedule sets out the milestones or timelines in which certain things need to be achieved before an employee can exercise their employee stock options.
The standard period of many vesting schedules is denoted “ four years with a one-year cliff,” and means that shares vest monthly after a one-year cliff. Pay attention to this portion of the agreement, as it includes important information about the consequences of leaving before the one-year cliff period.
Here is an article about when you should vest your options.
5. Early Exercise Option
The early exercise option of a stock option agreement, if included, outlines how an employee could exercise their stock options before becoming fully vested employees.
Because this option would depend on the employee to pay the cost to buy shares before taking vested ownership, since that constitutes a present payment, they may avoid short-term taxation.
Here is an article about things you need to know before using the early exercise option.
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6. Expiration Date
The expiration date is another important date dependent on the grant date. It is when the options expire, and the employee can no longer buy option shares. A common expiration date used is 10 years after the grant date.
Here is an article about the vesting and expiration dates of ESOs.
7. Incentive Stock Options
Also referred to as a qualified stock option, incentive stock options are one of the forms of employee stock options. These are commonly issued in start-ups to incentivize employees when there isn’t a lot of start-up capital to draw from.
Incentive stock options have a few stipulations:
- They are only eligible for current employees
- They have an annual limit
- They are only issued to a person, not to entities or companies
Taxes also come into play when an employee sells the shares and are not taxable when granted.
Here is an article with everything you need to know about incentive stock options.
8. Non-Qualified Stock Options
Non-qualified stock options, or NSOs, are the second form of employee stock options. In this option, the holder of the option is subject to income tax on the profit made when they exercise their shares.
Unlike ISOs, these non-qualified stock options:
- Can be granted to employees
- Can be granted to independent contractors
- Can be granted to non-employee directors
- Have no annual limit
Here is an article about the differences between ISOs and NSOs.
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