How Employee Stock Options Work?

How employee stock options work? Employee compensation has evolved over the years. There has been an addition of new incentives on top of the basic salary. One compensation method that has risen in popularity in recent years is stock options. Employee stock options are an investment-based incentive that allows employees to make a good amount of money down the road if the company and their work are successful.

While employees may not get immediate benefits from stock options, they can get a big payout if they stick with their employer for a certain time, and do good work. While stock options are relatively common among startups, more mature firms are also offering them to retain their workforce as well.

Since stock options only become exercisable after a certain period of time, companies can hold on to talent for longer with the help of this incentive. On the other hand, as long as employees join the company at its early stages, they can reap the fruits of their employer’s growth. With that being said, stock options can be complicated to understand for employees and employers alike. If you are looking to try to understand the concept of stock options, then keep reading.

What are stock options?

In their most basic form, employee stock options or ESO are contracts between an employer and the employees. When an employee is offered stock options by their employer, they have an option to buy shares in the employer’s business at a favorable price called the strike price.

However, employees often mistake stock options for shares and think they are getting a certain amount of shares in the company. While in reality, stock options merely give the employees the right to buy shares in a company at a great price. The word “options” is significant here since employees aren’t obliged to buy the stock; they can choose not to buy it.

The terms of stock options can be determined in a contract called stock options agreement, and they may vary from employer to employer. So, you may have to figure out how employee stock options work for you.

Stock options benefit employees.

The benefit for the employees multiplies as the company’s stock price rises above the strike price, and the higher the stock price is compared to the strike price, the bigger the payout for employees. With that said, some companies don’t give their employees much freedom to sell their stock options. However, once the employee has exercised their right to purchase stock options, they can choose to sell the stock or hold on until the stock rises further.

Startups utilize stock options more often because they typically don’t have the funds to offer competitive salaries to their workers. Since startups aren’t public, their stock still has a lot of growth potential. So if their employees believe in the startup and stick with it long enough, they can reap the fruits of their hard work and trust in the form of high stock price once the startup goes public.

At the same time, stock options are also common among fast-growing companies. Rapidly growing companies use stock options as an incentive for employees to help grow the company further and get rewarded for it in the form of higher stock prices.

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Non-Qualified Stock Option vs. Incentive Stock Options (What’s the difference?)

When an employer wants to give stock options or an employee is getting them from an employer, there are two types of stock options that may be involved. The first type is Non-Qualified Stock Options, and the second type is Incentive Stock Options. Both types of stock options are fundamentally the same but have differences in the way they are taxed. Here is how both types of stock options compare:

Non-Qualified Stock Options

Non-Qualified Stock Options or NSOs are called Non-Qualified because they don’t qualify for special tax treatment. When an employee exercises their stock options, the difference between the strike price and the actual stock price of the company at the time is taxed at standard income tax rates.

The difference between the special strike price at which employees exercised the stock options, and the actual stock price is considered as employee’s compensation by the IRS.

So at the end of the day, there is no special tax treatment for the amount the employees make by exercising their stock options if they had Non-Qualified Stock Options.

To understand NSOs better, consider an employee who got a strike price of $20 per share, and when they exercised the stock option, the stock’s market value was $30 per share. The difference between the strike price and actual stock price, which is $10 for this example, is taxed at standard income tax rates. Understand these basics about how employee stock options work.

Incentive Stock Options

Incentive Stock Options or ISO are highly favorable for employees because the payout employees get from these options qualifies for special tax treatment. So, in short, when an employee exercises their right to buy ISO stock at the strike price, the IRS generally doesn’t tax them the same.

If the employee manages to hold on to their ISO for more than two years following the date when they were issued, the ISO becomes qualified for lower long-term capital gains tax rates. It makes ISOs a more employee-friendly form of Stock Options.

How do stock options work?

Stock options are given when an employee joins an organization, so the strike price employees get is usually the value of the company’s stock at that time. However, since stock options are not just offered by large mature companies but also by startups, the valuation of the strike price can be tricky for startups. A public company will simply look at the price their stock is trading to set the strike price for their options.

However, startups have to get the right strike price for their options by valuating their company by independent valuation providers. However, the strike price is often further reduced as a means to offer even more of an incentive for employees.

Employee stock options are not traded at any exchange, as mentioned earlier, but instead, a company will specify a certain amount of shares that are given to employees as options. Setting a limit to the number of options helps prevent dilution of stock and keeps the investors interested while compensating employees for their hard work.

Signing the contract

When an employer offers stock options to an employee, they sign a contract with the worker that contains the following clauses:

1. Exercise date: The date at which employees exercise their stock options.
2. Vesting period: The Vesting period is the time that has to pass before employees can exercise their stock options.
3. Option expiry date: The deadline before which you have to exercise your options, or they become invalid.
4. Strike Price: The price at which you are entitled to buy stock, no matter what the stock’s actual price is at the time you choose to buy.

These are just some basic items that are always part of a stock options agreement. However, an employer may add more terms to the agreement to make it more detailed if they want. Employees can use the strike price, vesting period, exercise date, and other clauses being offered by various employers for their stock options to choose the best offer.

Understanding the vesting period

The vesting period holds significant value for employers as it determines how long employees have to work at the company to vest the right to own stock. Therefore, the vesting period is often used by employers to keep employees working for them for longer. Often, the vesting period is four years, and if the employee leaves before the 4-year vesting period is completed, they forfeit their right to stock options. This factor is one of the nuances of how employees stock options work.

Some companies may also have a cliff vesting period which means employees get access to a 100% of their stock options after the cliff period passes.

The vesting period can be better understood using the following example. When employees of an organization get stock options, the first year after joining gives them access to 25% of the stock options. The second-year gives them access to 50% of the options and so on. Once the four-year vesting period passes, the employees can access 100% of the options.

Common mistakes made by companies when issuing stock options

Now we have established that stock options have something to offer for both companies and employees alike. However, most companies that are issuing stock options end up making some mistakes that can cause issues later on. With that said here are some common mistakes companies make when issuing stock options:

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Failing to get your startup valued

Since startups don’t have their stock being traded in exchanges because they are private, they have to determine the fair market value for their strike price.

Undervaluing the strike price is a common mistake made by companies. If a company has set the strike price lower than the legally defined fair market value, the employees may suffer higher interest penalties. So getting your company evaluated before issuing stock options is not just good, it is essential to avoid problems and penalties down the road.

Not creating vesting schedules

While it is true that stock options can greatly improve a company’s employee retention, it is only possible when employees know their vesting period. If employees can’t see how their vesting period progresses, they aren’t going to be motivated to stick around.

A vesting schedule tells employees how many options they vest after spending a certain time in the company. When employees can visualize their vesting period from the start, the chances of them staying through the vesting period increase significantly.

However, setting up a vesting schedule may not be enough to improve employee retention. Companies go one step further and implement smart tracking systems that track the vesting periods of various employees.

Similarly, sending emails about what stage of vesting period an employee is in will make it even easier for employees to track their stock vesting progress.

Not issuing stock options at the right time

Stock options are best issued when the company’s stock price is still low. That is because the lower stock price means the employees can benefit from the lower strike price and will be motivated to join and stay with your company. However, if you issue stock options when your company stock has increased in value, the strike price will also be higher, giving employees less incentive to join in.

A good time to issue stock options is before you receive an investor term sheet so you can transfer the low strike price benefits to your employees.

Not getting approval from the board: Before stock options can be issued, board members have to approve the issuing of options. If the board members haven’t shown consent to issuing stock options, founders can’t issue stock options.

Any stock options that are granted without the consent of the board will need to be reissued, which will cause issues for the company and employees. So before you move on with the actual issuance of the stock options it is essential to hold a meeting of board members or get written consent from them.

Conclusion

Knowing how stock options work is equally important for employees and employers alike. Now that you know what employee options are, their key types, and how they are issued you can make a more informed decision about whether to issue or get stock options or not.

Stock options are an integral part of compensation and they are here to stay. Employees expect them and startups love them and as long as they are issued correctly they are beneficial for both parties involved.

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