Employee Stock Options: How They Work

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What Are Employee Stock Options (ESOs)?

Employee stock options (ESOs) are a stock-based form of compensation employers offer to employees. In short, private companies grant ESOs to employees, which are governed by a legal agreement that gives the employee the right to purchase the shares in the future at a pre-determined price, called the exercise price.

ESOs are commonly used as incentives for employees to be high-performing since they may benefit in the increased value of the stock price. They can also be used to promote employee retention since they typically have a vesting period tied to time, which means an employee will need to stay at a company for a certain amount of time to earn their shares.

There are two different types of employee stock options, which are below:

  • Incentive Stock Options (ISO) – ISOs are stock options that have the ability to qualify for preferential tax treatment. For this reason, ISOs are also known as qualified stock options.
  • Non-qualified Stock Options (NSOs) – NSOs are the most common and, as their name infers, do not qualify for special tax treatment from the Government.

Here is an article where you can read more about incentive stock options.

Here is an article where you can read more about non-qualified stock options.

Understanding How Employee Stock Options Work

Employee stock options are primarily used to incentivize the performance of an employee by giving them ‘skin-in-the-game’ with the ability to benefit directly from their hard work. The way an employee would benefit is by the price of the stock to increase while holding the options.

ESOs are essentially a promise by a company to purchase shares in the future at a pre-determined price. In other words, a company will grant you stock options with an exercise price that reflect the fair market value of the stock at that point in time. You will have the ability to buy the stock at that exercise price in the future, when the shares should hypothetically appreciate in value.

For example, if you are granted 1,000 shares of options with an exercise price of $5 per share, and the shares appreciate to $25 per share by the time you are fully vested, you will be able to buy the 1,000 shares for $5,000, when they are currently worth $25,000. As a result, you will have netted $20,000 worth of value in the form of shares.

In order to better understand employee stock options, you will need to familiarize yourself with certain important terms.

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Important Terms For Employee Stock Options

  • Number of Shares – The number of shares is the total number of options shares an employee is granted. These are the shares an employee will be able to buy in the future.
  • Exercise Price – The exercise price is the pre-set price offered to the employee at the time of the grant that should reflect the fair market value of the shares at the time of the grant. The exercise price is also the price at which an employee will be able to buy the shares for at a future date.
  • Exercise Method – The exercise method is the way the employee plans to pay for the shares in the future. Examples of the exercise method can include cash or stock swaps.
    • Cash is a common exercise method.
  • Grant Date – The grant date is the date at which the company issues the stock options. The grant date is important since the expiration date is typically based on the grant date.
  • Vesting Schedule – The vesting schedule outlines the time or milestones needing to be achieved before the employee can elect to purchase the shares.
    • Four years with a one-year cliff is a common vesting schedule, where shares vest on a monthly basis after the one-year cliff.
  • Expiration Date – The expiration date is the date at which the options expire and the employee will no longer be able to buy the option shares. This is typically years after the grant date.
    • 10 years is a common expiration date.

Here is an article that goes further into employee stock options.

Types of Employee Stock Options

There are two types of employee stock options issued by employers. The options share the same characteristics and terms above, but have a difference as it relates to taxation.

Incentive Stock Options (ISOs)

An incentive stock option (ISO), also known as a qualified stock option, one form of employee stock options that has potential tax benefits. Employees who exercise ISOs and meet certain qualifications will benefit from the capital gains tax rate, as opposed to the ordinary income tax rate, on the profit earned from purchasing the shares.

ISOs are commonly used in early-stage startups.

Non-qualified Stock Options (NSOs)

A nonqualified stock option, also known as an NSO, is another form of employee stock options offered by employers wherein the option holder pays ordinary income tax on the profit made when they exercise the shares.

Unlike ISOs, NSOs can be used with contractors and consultants and not just limited to employee.

Here is an article on the difference between ISOs and NSOs.

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Employee Stock Options Plan Example

ESOs can be complicated, so let’s walk through an easy-to-understand example so you get it.

  • John is an early employee at a technology startup in Salt Lake City.
  • John is offered 25,000 shares in the form of employee stock options as part of his compensation package.
  • In the employment contract , the terms of the options are below:
    • Number of Shares: 25,000
    • Grant Date: January 1, 2020
    • Exercise Price: $1 per share
    • Expiration Date: December 31, 2030
    • Vesting Schedule: Four Years Vesting Schedule, One-Year Cliff, Shares Vest Monthly Thereafter
  • In summary, John will have 25% of his shares (6,250) vest after one-year of service and the remaining will vest evenly with each incremental month.
  • John will have the option to buy shares at $1 per share in the future.
  • If there is a liquidation event that triggers the sale of shares (say an acquisition) and the price of the shares have increased to $20 per share, John will be able to exercise the options at $1 per share despite them being worth $20 per share.
    • John would pay $25,000 for 25,000 shares that would be worth $500,000, netting John $475,000 – nice pay day!

This is just one example of how options can play out. It is important for you to understand that options can also be worth nothing in the future.

Here is an article that has another example of how they work.

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Employee Stock Options Tax

Employee stock options become taxable once they are exercised by the employee. Your tax liability will be dependent on the type of options you hold.

  • Non-qualified stock options : These types of options are taxed at the ordinary income rate and will go on your W-2 income.
  • Incentive stock options : These types of stock options can qualify for special tax treatment and be taxed at the capital gains rate.

If you want to better understand tax implications for your options, feel free to browse our tax lawyers . They will be able to guide you through the what to expect if you choose to exercise your shares.

Here is an article that has a table with the difference in tax liability between ISOs and NSOs.

Who Can Help You Understand ESOs

If you have any questions about employee stock options or you want to find a lawyer to review an offer you have from a potential employer, feel free to post a project and receive free bids to review your agreement from qualified lawyers.

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