Employee stock options: Pros & cons and how they work

Employee stock options are a common equity compensation type granted by companies in the ongoing battle to help recruit, retain and motivate employees. They are a popular choice for tech companies and startups but are not used exclusively by them and can also help other types of businesses to thrive.

What are employee stock options?

Employee stock options are an equity award that gives the holder the opportunity to exercise (i.e. purchase) shares in the company at a pre-set price at a future date, as opposed to directly granting them actual shares.

That pre-set price is called the exercise price or strike price. In the US, the exercise price is typically set at the fair market value (FMV) of the underlying stock as of the date the stock option is granted.

Whenever the stock’s market value is greater than the exercise price, the option is said to be ‘in the money’. Conversely, if the market value is less than the exercise price, it is called ‘underwater’. Holding underwater stock options is not an ideal situation and some companies may choose to allow their staff to exchange their underwater options during times of stock market volatility.

Types of employee stock options

There are two key types of employee stock options: incentive stock options (ISOs) and nonqualified stock options (NSOs).
– ISOs can be given to employees only. They offer the holder a more favorable tax treatment if the shares are held for a specified period but are subject to alternative minimum tax (AMT) which can be a complex tax event. ISOs also come with more restrictions than NSOs, like a $100,000 grant limit and exercise price limit.
– NSOs can be given to non-employees, like contract staff, directors and vendors. They also have fewer restrictions and an easier-to-understand tax structure but don’t qualify for the favorable tax treatment given to ISOs.

Learn more about ISO vs NSO.

How do employee stock options work?

No matter which type of options it is, there are typically four stages in the life cycle of employee stock options: Grant-> Vesting-> Exercise-> Sale

1) Grant: Employee stock options are awarded at an exercise price. It’s usually equal to the stock’s market value at the time the option is granted.

2) Vesting: Vesting is a waiting period to earn the right to exercise the options. It can be a time-based or performance-based process. Check out our ‘’What is Vesting’’ guide.

3) Exercising: Once the vesting period has passed, stock options can be exercised at the exercise price. (Note: some companies allow early exercise of unvested option shares.) When the holder exercises their stock options they may be taxed, depending on which stock option type they hold.

4) Sale: Stocks can be sold right after exercising. Capital gains will be taxed at sale.

Benefits of stock options for employees

1. Potential financial rewards

Compared to cash bonuses, equity-based awards, such as stock options can potentially provide employees with benefits higher than cash-based awards if the company is a success, i.e. the amount the employee gets is based on the company’s stock price and/or performance over time. This explains why some companies have created millionaires from stock options. It is important to note however that not all companies are success stories and companies can fail or thee stock’s value can drop.

2. Tax Benefits

Incentive stock options (ISOs) are tax-efficient employee stock options. No income is recognized for regular tax purposes at the time of exercise although AMT may have to be paid at exercise.

If they hold on to their shares for set time they may only owe long-term capital gains at sale. Long-term capital gains are taxed at a favorably low rate.

Benefits of stock options for employers

1. Your employees think like owners

Stock options give employees an opportunity to have ownership in the company. It means they are likely to behave as an owner and align their own goals more with the company’s missions and goals.

2. Improve employee morale and motivation

The better the company does, the greater the rewards. Employees are incentivized to work harder and be more productive as their performance can positively impact how much they can earn.

3. Increase employee retention

Issuing stock options tends to result in improved staff retention because most employee stock options vest over a number of years. In these plans, participants receive a part of the grant each year, spread out over a number of years, rather than one upfront payment, which is often have cash-only rewards are delivered.

This vesting period gives the participants a greater incentive to stay with the company for longer. If they leave early, then they won’t receive the full value of their award. At an up-and-coming startup or a company that has linked the vesting to an IPO that could mean potentially leaving a lot of money on the table. Employees may be reluctant to walk away and instead choose to stick around to reap the rewards of their hard work.

Any downsides of employee stock options?

Employee stock options can be a helpful way to make your company thrive. With an ownership-focused mindset, they can help improve staff’s happiness and incentivize them to work harder. However, there are some downsides:

• Options being worthless if the stock value of the company doesn’t grow
• The possible dilution of other shareholders’ equity when option-holders exercise their stock options.
• Complex tax implications for ISOs, especially the concept of AMT.
• Extra management and administration workload for your existing departments to manage the plan – everything from tracking and reporting changes in ownership to updating documents/policies/procedures, communicating with stakeholders, consulting your board of directors and staying compliant.

Key things to know before introducing a stock options plan

– Type of employee stock options: Will you be granting incentive stock options (ISOs) or non-qualified stock options (NSOs)?
– Number of stock options to be offered: This number is important as it will determine your company’s total compensation package. Your employees also need this to figure out how much they have to pay if they want to exercise their options. [Total exercise price = No. of options x Exercise price($)].
– Exercise price or strike price: Every employee stock option has an exercise price which is the price at which a share can be bought at an exercise date.
– Vesting schedule: Vesting is a process of earning the ownership of your equity. A common vesting schedule for stock options is 4-year vesting schedule with a 1-year cliff.
– Vesting commencement date: Linked to the vesting schedule.
– Methods to exercise options: Some common methods include monetary payment, sell some to cover and, exercise and sell all. Some companies allow for early exercise. View different methods of exercising stock options here.
– Expiration date: Employee stock options often expire 10 years from when they’re issued if they are not exercised. You will need to determine this in your plan rules.
– Time allowed to exercise upon termination: If an employee leaves the company they will typically have a window of 90 days to exercise their options. If they don’t do so within the timeframe, the options will typically expire. Again you will need to determine this in your plan rules.
– Transferability restrictions

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As you can see when determining whether to introduce stock options as a form of employee equity compensation there is a lot to consider.

At J.P. Morgan Workplace solutions we provide employee equity management solutions for businesses of all sizes the world over. You not only get the benefit of our all-in-one automated platform to handle the day-to-day administration, but you also get access to a robust team of equity specialists who can work with you to develop an employee stock option plan designed to meet your needs.

Contact us for a no-commitment demo today.

FAQs about employee stock options

How do employee stock options work?

No matter which type of options it is, there are typically four stages in the life cycle of employee stock options: Grant-> Vesting-> Exercise-> Sale. At grant, employee stock options are awarded at an exercise price. Once the vesting period has passed, stock options can be exercised at the exercise price. Stocks can be sold right after exercising

What are the advantages of employee stock options?

For employers, employee stock options can improve employee morale and motivation, increase staff retention and encourage employees to think like owners. For employees, stock options can provide potential financial rewards with tax benefits.

What are the disadvantages of employee stock options?

Options will become worthless if the stock value of the company doesn’t grow. It is also possible to dilute other shareholders’ equity when option-holders exercise their stock options.