Employee Stock Options: Guide and How It Works

employee stock options
Image source: Corporate Finance Institute

Employee stock options allow them to purchase a portion of your firm at a reduced price in reward for their effort and commitment. As a small firm, selling stock options provides benefits to employees while also building a productive and imaginative team. Here, we’ll explain how these employee stock options work, their various types, and how you can create a good stock options plan. 

Employee Stock Options: What Are They?

Employee stock options (ESOs) are a type of equity remuneration given to employees by firms. They provide employees the right to buy a particular number of shares of the company’s stock at a specified price (the “strike price”) for a set period of time. ESOs are frequently distributed as part of a company’s stock option plan.

How Do Employee Stock Options Work?

Many businesses choose to give their staff stock options because they can be mutually advantageous. For example, both Microsoft and its employees have reaped significant benefits from stock options. According to The Washington Post, in 1987, a 28-year-old Microsoft marketing assistant was pondering leaving the company. He threw his option statements in a desk drawer, though, and stayed for another five years. He retired a millionaire at the age of 38, thanks to his stock options and Microsoft’s phenomenal early success.

A stock option contract will normally state when the stock options will begin to vest or when employees will be able to sell the stock. The contract will also specify how many shares can be sold. For example, a contract may provide that an employee will get 10,000 shares over the course of four years, with the option to exercise all of the shares within four years.

There will often be a waiting time before stock options vest. This is referred to as “the cliff.” Typically, a person must work for a company for a specified amount of time before their stock options become exercisable. This provides an incentive for the employee to stay with the company for as long as it takes to benefit from their stock options.

Who makes use of Employee Stock Options?

Employee stock options are most typically employed by a company’s high-level employees, such as executives or managers. These employees are frequently offered the option to acquire business stock at a predetermined price that is usually lower than the market price. This permits the employee to purchase the shares at a discount and subsequently sell them for a profit at the market price. Employee stock options can also be utilized to compensate employees, especially if the firm is performing well.

Stock Option Exercise

Stockholders can exercise their options in three ways. Employees can first purchase stock with cash. Stockholders must pay commissions, fees, and taxes. Second, the owner of the options can immediately buy and sell shares. Again, the individual must pay for the stock, as well as the commissions, fees, and taxes. Third, individuals can exercise their option by selling enough stock to cover the purchase price, commissions, fees, and taxes, while keeping the remainder in the form of company shares.

Types Of Employee Stock Options

Employers provide two kinds of employee stock options: non-qualified stock options (NQSOS) and incentive stock options (ISO) (ISOS).

The most common type of stock option is an NQSOS option, which is not entitled to special tax treatment by the Internal Revenue Service (IRS). Employees, contractors, and consultants can all be given these options.

An ISOS can only be granted to employees, and it has several restrictions. The aggregate amount of the ISOS grant that can be vested in any calendar year is limited to $100,000, and employees must exercise their shares within three months after leaving the company. The advantage of ISOS over NQSOS is that any gains that would otherwise be classified as compensation can be classified as capital gains, which are taxed at a lower rate than compensation taxes. The discount is deemed compensation for NQSOS at the time the stock is exercised.

What Are The Benefits Of Stock Options For Employees?

Employee stock options (ESOs) allow employees to buy shares of a company’s stock at a predetermined price that is usually lower than the market price. Because they offer the possibility of a big financial gain if the stock price improves, ESOs can be a tremendous incentive to work hard and stay with a company. They can also be used by a corporation to provide its personnel with a stake in the company’s future success. 

Benefits Of Stock Options For Employers

#1. Recruit and retain talented employees

Most businesses are acutely aware of the difficulty in attracting outstanding employees. Employers, like successful sports teams, must “develop” their own talent or recruit experienced players from other teams. Even in a depressed economy, top recruiting organizations like Kelly Services and others, as well as broad employer-sponsored searches, seek the best available personnel. Offering meaningful stock options both recruits and retains better, more capable people over time.

#2. Increase the number of dedicated employees

Employers are continuously seeking to motivate and retain staff. Volumes have been published on the subject, and several “experts” and consultants have a plethora of theories, suggestions, and programs to offer. Stock options are a key perk that businesses employ to increase motivation and dedication. When employees use their stock options, they usually become more devoted to the success of the company. Their stock value is determined by company performance, which is, of course, a direct result of employee achievement. Stock options have historically created incentives and dedication for all personnel involved since they are more invested in the firm and its success.

#3. Company Gains at a Low Cost

As the cost of all employee benefits continues to rise, businesses are looking for programs that provide excellent value at a low cost. Stock option schemes are frequently found to be both beneficial to employees and cost-effective for businesses. While stock options are rarely alternatives for pay raises, they can help make employment packages more appealing when combined with a robust benefits package. The only significant costs to the corporation are the missed opportunities to sell some stock at market value (since employees often buy at a discounted rate) and the administrative costs of the plan. In addition to their capacity to attract, retain, and motivate employees, stock options enable many smaller businesses to compete with larger enterprises by providing comparable benefit schemes.

How to Create a Stock Option Plan for Employees

It is not difficult for high-growth companies to develop an employee stock option (ESO) plan — but only with the correct tools and initial investment. Any challenges or infractions of regulations throughout this procedure can result in significant consequences for founders and their boards, including penalties and legal exposure. So, here’s how to get off to a good start.

#1. Understand The Employee Stock Option Plans

An ESO is a sort of equity remuneration offered by firms that allow employees to participate directly in the success of a company’s growth. Startups frequently grant stock options to early workers in the event that the firm goes public. Other rapidly growing organizations utilize them as incentives, so staff tries to increase the value of company stock.

Employers use ESOs to provide derivative options on the stock rather than equity shares directly. This strategy grants employees the right to purchase business stock at a preset price for a set length of time.

When the price of a stock climbs over the option exercise price, the employee receives a discount on the company’s stock. They can either sell the shares on the open market or keep them.

#2. Understand the ESO Benefits for Companies and Employees.

Our most significant assets are our people, but they are changing employment quicker than ever during the Great Resignation. As a result, retaining great staff is a top priority for firms everywhere.

When the competition for talent is high, ESOs are more than just a cost-effective recruiting tool. There is also an obvious link between awarding these stock options and long-term staff retention and profit-maximizing conduct. Employee satisfaction and financial well-being are greatly improved by ESOs, and with a stake in the company, people are more driven to support company growth.

Employers are also protected by stock options, which require employees to work for the company for a set period of time before receiving access to their stock options. This strategy protects the company’s equity while reducing staff turnover.

Furthermore, ESOs provide a viable exit route for owners intending to sell their company while maintaining business continuity. Owners can almost choose their purchasers and leave a legacy for their committed employees by selling the company to employees.

#3. Get to the Bottom of Setting Up an ESO

The first phase is to collaborate with the founders, board, and advisers to create the ESO’s philosophy. Then, utilizing your company’s mission and values as a foundation, you must:

  • Discuss how to convey this ESO incentive to prospective employees.
  • Determine how much ownership of the company will be distributed to early employees vs those who join later.

After receiving approval from the board on these recommendations, you can begin planning. Maybe you’ll sell your stock grants in 100-share increments or distribute them differently. Make a note of it. Also, consult with your legal counsel to ensure that you have all of the essential permits to comply with state and federal legislation.

The most difficult difficulty for firms when it comes to equity pay is effectively articulating the benefits to employees. As a result, the implementation could incorporate the use of a digital platform with employee access to foster an ownership culture. Employee stock programs that are passive have previously been shown to benefit from employee retention, but imagine the increased value when there is an additional layer of participation.

#4. Upholding the ESO

It is critical to assign someone within the organization or use equity management software to manage your cap tables in accordance with Internal Revenue Service (IRS) requirements. The correct capitalization table software can help you avoid costly blunders caused by human error.

The IRS will give you high marks for valuing your stockholders and employees if you utilize a respected valuation firm. Always be mindful of when you require a new valuation: If your valuation is more than a year old or you accomplish a key financial milestone, you should acquire a new one as soon as possible.

Underfunding your equity budget and rewarding new employees is a common mistake that might expose your company to legal responsibility. As a result, ensure that your hiring staff is aware of the equity budget. The number of stock options required for new employees can be determined by the hiring plan. Examine the stock option allocation on a regular basis to ensure that it will sustain future hires, and bring it to the board immediately if there is a shortage.

#5. Creating ESO Offers

Collaborate with an experienced attorney and accountant to establish employees’ residency and work visa status before making an offer, lowering the possibility of difficulties later on. There are a couple more items to cross off the list:

  • Declare the kind of stock options that will be granted to workers (ISOs or NSOs).
  • Explain the value in terms of the number of shares rather than the company’s proportion.
  • Declare that any stock option grant amounts must be approved by the board before the offer letter becomes legitimate.
  • Ascertain that employees are aware of any tax implications linked with their equity remuneration.
  • Remember to provide employees with a final, signed copy of the agreement.

Company directors and officers have a fiduciary responsibility to their employees and shareholders, thus it’s critical to include a detailed description of the ESOs in your employee handbook.

Then, for your whole employee pool, update your Employment Practices Liability (EPL) insurance — this is just as important for on-site employees as it is for remote workers.

Finally, evaluate your Directors and Officers (D&O) insurance policy, which insures and protects your leaders’ personal assets as well as the firm itself from claims. Allegations against directors and officials are common these days, although the majority of them arise from mismanagement.

There are three levels of D&O insurance to consider:

Side A: If a director is named in a lawsuit and required to pay defense expenses and settlements, this element of D&O insurance comes in to protect the director. Side A, on the other hand, will only compensate the individual directors if the corporation is unable or unwilling to cover them. This could be due to the company’s insolvency or because the claim violates the company’s bylaws.

Side B coverage reimburses costs incurred when the entity indemnifies persons named in the case. However, it only applies to the insured individuals cited in the complaint.

Side C: This coverage protects the corporation listed in the case as well as an individual executive’s balance sheet. The costs and settlements will be reimbursed under Side C coverage.

What Happens To Stock Options When You Leave A Company?

When you leave, you should be able to execute the vested component of your stock option awards and forfeit the unvested portion.

What Happens When You Exercise Stock Options?

Exercising a stock option entails purchasing the issuer’s common stock at the option’s stated price (grant price), regardless of the stock’s price at the moment the option is exercised.

In Conclusion,

Employee stock options (ESOs) are a type of equity remuneration given to employees by firms. Employees are incentivized by stock options because if the firm does well, so will the stock options that the employee owns. Employees who are productive and increase corporate earnings will benefit as a result. 

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