Everything You Need To Know About Employee Stock Options (With Examples)

Understanding compensation packages can be complex. One increasingly popular benefit, particularly among start-up companies, is employee stock options. Once primarily reserved for executives, stock options are now offered to employees at all levels.

In this article, we’ll explore what employee stock options are, provide examples of how they function, and discuss their tax implications.

Key Takeaways

• Employee stock options give you the right to purchase a specified number of shares in your company, typically at a discounted price.

• Employee stock options have expiration dates, which can be affected if you leave the company before exercising your options.

• Employee stock options are frequently included in compensation packages, especially at start-ups.

What Are Employee Stock Options?

Employee stock options (ESOs) grant employees the right to purchase company stock at a predetermined price within a specified timeframe. These options do not represent free shares; rather, employees have the choice to buy them. Consider ESOs as an opportunity for discounted shares in the company.

The predetermined stock price is known as the “grant price,” “strike price,” or “exercise price.” While shareholder approval is generally required, employers typically have flexibility in deciding the grant price and the number of stock options offered.

Employee stock options come with expiration dates, which can shorten if you leave the company before exercising your options.

Stock options can form a significant part of your overall compensation package. They are often used by start-up companies that may not have the budget to offer competitive salaries. Instead, they provide the potential for a substantial financial reward in the future.

How Employee Stock Options Work

To understand how employee stock options function, it’s important to familiarize yourself with several key steps and terms:

1. Sign an employment contract with ESOs. Your employer will offer you a specific number of stock options to purchase shares at a pre-set price. You agree to these terms when you sign your employment contract here.

2. Wait for the “cliff.” ESOs generally include a “cliff,” which is the waiting period before you can exercise your options. Companies often implement a one-year cliff, meaning you must wait one year before you can access your options.

   If you leave the company before this period, you forfeit your stock options, encouraging retention.

3. Understand the vesting period. Besides the cliff, ESOs have a vesting period (similar to 401(k)s). A common arrangement includes a four-year vesting period, meaning after four years, you can purchase the shares specified in your contract.

   Options vest over time; for example, in a four-year vesting period, you can exercise 25% of your options after your first year, 50% after your second year, and so on.

   Depending on your contract, options may vest either monthly or annually. In our example, you would gain access to an additional ~2% of your options each month, or 25% each year.

4. Exercise your options. Once a certain percentage of your options have vested, you can exercise them, meaning you buy stock in the company.

   The grant price remains fixed regardless of the company’s performance. Your stock options have no intrinsic value until you exercise them.

   You have several options when exercising your stock options:

   • Buy the stock. The most straightforward option is to purchase the stock and hold it. You will need to cover any commissions, taxes, or fees associated with your broker.

   • Sell the stock. After purchasing the stock, you can immediately sell it at the market price.

     Brokerages may provide funding for the initial purchase, allowing you to exercise your option without significant upfront cash. You can then keep the profits after deducting any brokerage fees.

   • Sell some and keep some. To minimize cash outlay, you can sell enough stock to cover the purchase price and associated fees while retaining a portion of your shares.

     This strategy can be advantageous, allowing you to invest in the company without an upfront cost.

It’s important to note that stock options are only valuable if the grant price is lower than the market price of the stock. If the grant price exceeds the market price, your option is considered “underwater,” and exercising it would not be beneficial.

Employee Stock Options Examples

To better understand how ESOs work, let’s examine a practical example involving Sara, a new employee at a start-up with stock options in her employment contract:

Now, let’s consider different scenarios if Sara decides to quit or is terminated:

Employee Stock Options and Taxes

Gains from stock options are typically subject to taxation. There are two primary categories of stock options:

• Non-qualified stock options (NQSOs). These are the most common type and do not receive special tax treatment from the federal government.

• Incentive stock options (ISOs). These are usually granted to high-level executives and enjoy preferential tax treatment.

For NQSOs, profits are treated as regular income. Your company will report your income from exercising options on your W-2.

For example, if you exercise an option and sell it for a quick profit of $2,500, that amount will be subject to income tax. This is classified as a “short-term capital gain” but taxed as regular income.

However, if you hold onto your shares for over a year, your tax burden may be lower due to the “long-term capital gains” tax rate.

Employee Stock Options FAQ

1. Should you take a bigger salary or employee stock options?

   It’s advisable to opt for a bigger salary over employee stock options. Employee stock options are most beneficial when they complement a salary you’re comfortable with, as salaries are guaranteed while stock options may or may not yield a return.

   If you secure a desirable salary, consider taking stock options as an additional benefit, but avoid accepting a lower salary just for stock options.

2. Do I lose my stock options if I quit?

   Yes, you typically lose your stock options if you quit, but not immediately. You often have a grace period to exercise your options before they expire, commonly around 90 days, though this varies by company.

   Therefore, when resigning, be sure to review your stock options, as your former employer isn’t required to remind you of this opportunity.

3. Is it good to buy employee stock?

   Buying employee stock can be advantageous if approached thoughtfully. As with any stock purchase, it’s essential to evaluate the associated risks and rewards. If you have the financial means and believe in the company’s future, it could be a profitable investment.

   However, consider the increased risk when investing in a startup, which may offer higher potential rewards but also greater volatility. Consulting a financial advisor can provide additional insights.

Final Thoughts

Employee stock options can be a valuable yet risky component of compensation packages that employers offer to incentivize employees. As a potential shareholder, you can directly influence the company’s value.

However, it’s important to approach expected compensation through stock options with caution. Start-ups often use ESOs to compensate for lower salaries, meaning you may be accepting reduced immediate pay in hopes of future gains.

That said, stock values can fluctuate significantly based on company performance or broader economic conditions. Additionally, you might not remain with the company long enough to benefit from your options.

Ultimately, stock options could either be a lucrative opportunity or a negligible part of your compensation package. It’s essential to evaluate the company thoroughly and make informed decisions. There’s no definitive answer to whether accepting a job with stock options is right for you.

Still, it’s advisable to avoid working for a company solely for the potential long-term payoff unless you are genuinely excited about the opportunity.

Author

Matthew Zane

Matthew Zane is the lead editor of Zippia's How To Get A Job Guides. He is a teacher, writer, and world-traveler that wants to help people at every stage of the career life cycle. He completed his masters in American Literature from Trinity College Dublin and BA in English from the University of Connecticut.