What Is an Employee Stock Option?
Companies use various strategies to incentivize their workers. Cash compensation is the predominant way to motivate workers, but stock options are also a way to supplement employee compensation and encourage productivity.
Stock options are the right to purchase shares in a company, usually over a period and according to a vesting schedule. With a stock option, an employee is given a certain percentage of ownership in the company they work for in the form of shares. If the company grows, the employee will see their shares increase in value. Basically, as the company profits, employees profit as well. Thus, stock options are a way to create a loyal partnership with employees.
Key Takeaways
- Stock options are a way for companies to motivate employees to be more productive.
- Through stock options, employees receive a percentage of ownership in the company.
- Stock options are the right to purchase shares in a company, usually over a period and according to a vesting schedule.
- Stock options are also a way for companies to free up cash for the company that can be spent in other ways.
How Do Employee Stock Options Work?
Many companies choose to offer stock options to employees because they can be mutually beneficial. For example, both the company Microsoft and its employees have benefited tremendously from stock options. According to The Washington Post, in 1987, a 28-year-old marketing assistant for Microsoft was considering leaving the corporation. However, he tossed his options statements in a desk drawer and stayed for another ten years. Thanks to his stock options and Microsoft's meteoric early growth, he retired a millionaire at age 38.
A stock option contract will typically list the date when the stock options will begin to vest or the date when employees can sell the stock. The contract will also state the number of shares that can be sold. For example, a contract might show that an employee will receive 10,000 shares over four years, and they can exercise all the shares in four years.
In many cases, there will be a waiting period before stock options vest. This is called “the cliff.” Typically, an employee will have to complete a certain period of employment with a company before their stock options kick in. This gives the employee an incentive to stay with the company for as long as it takes to benefit from their stock options.
Exercising Stock Options
There are three ways for stock owners to exercise their options.
- Buy stock with cash: Stock owners will have to pay commissions, fees, and taxes.
- Buy shares and then sell them right away: Again, the individual will have to pay for the stock, the commissions, fees, and taxes.
- Sell some, keep some: Employees can also exercise their option and sell enough stock to cover the price, commissions, fees, and taxes, and keep the rest in the form of company stock.
Types of Employee Stock Options
Employers offer two types of options: non-qualified stock options (NSOs) and incentive stock options (ISOs).
Non-Qualified Stock Options
An NSO option is not eligible for special tax treatment by the Internal Revenue Service (IRS) and is the most common type of stock option. These options can be offered to employees, contractors, and consultants.
Incentive Stock Options
An ISO can only be issued to employees, and there are certain limitations. There is a limit of $100,000 on the aggregate value of the ISOS grant that can be vested in any calendar year, and employees typically must exercise their shares within three months of leaving the company.
The benefit of ISOs over NSOs is that any gains that would otherwise be treated as compensation can be considered capital gains, which have a lower tax rate than compensation taxes. For NSOs, the discount is considered compensation at the time when the stock is exercised.
Advantages and Disadvantages of Employee Stock Options
In addition to the obvious advantages concerning staff motivation and retention, there are financial advantages for an employer who chooses to offer stock options—but there are some drawbacks, too.
Advantages
Free up cash that can be invested back into the company
Employees are motivated to be more productive
Can strengthen the employer-employee relationship
No extra cost for the employer
Disadvantages
Executives might make risky decisions to boost stock price
Cash incentives are often more effective motivation
Stock options can dilute the stock price
Benefits
- Free up cash that can be invested back into the company: Companies can use stock options as a way to free up cash that they can put towards other aspects of the business. For example, if staff compensation shifts from 100% cash to 80% cash and 20% stock options, there is more cash to spend elsewhere.
- Employees are motivated to be more productive: When the company does better, employee stock rises in value.
- Can strengthen the employer-employee relationship: Not only do stock options add to an employee's compensation and benefits package, increasing morale, but it also provides more interconnection between employee and employer.
- No extra cost for the employer: It doesn’t cost an employer anything to issue stock options. In fact, an employer may be able to offer a lower salary to an employee who is also eligible for stock options.
Disadvantages
Another disadvantage is that an individual employee must rely on their coworkers and supervisors' collective output to be compensated regardless of their own individual hard work and performance.
- Executives might make risky decisions to boost stock: Some high-level executives may receive stock options as part of their compensation package even though business success might be mediocre.
- Cash incentives are often more effective motivation: Cash is immediate, direct, and flexible, while options aren't.
- Stock options can dilute the stock price: Stock options might have a dilutary effect, which may reduce the value of the stock in the long run.
How Do Stock Options Incentivize Employees?
Stock options incentivize employees because if the company does well, so will the stock options that the employee owns. Thus, when employees are productive and boost company earnings, they will benefit. Also, employees are often required to work for the company for a certain period before they can exercise stock options, which encourages them to stay with the company and not leave to work for a competitor.
Do You Have to Pay for Employee Stock Options?
When you receive employee stock options, you pay when you exercise the option. That's when you purchase the shares at the strike price laid out in the options contract. If you don't exercise the options, you don't have to pay for them. You could let them expire instead. You could also choose "exercise-and-sell," which is when the brokerage fronts you the money to exercise the option and then collects the proceeds from the sale to cover the expense. You'll receive the profits left over.
What Does It Mean If My Employer Gives Me Stock Options?
When your employer gives you stock options, it means they're giving you the right to purchase a set number of shares of company stock at a particular price. These options are part of your total compensation package, and may be a way to incentivize you as the employee to work hard and stay with the company so you can exercise them.
The Bottom Line
Stock options are a popular way for companies to build a strong relationship with employees and to motivate them to work hard in the interests of the company. Stock options are also a way to encourage employees to stay and not be tempted to leave and work for a competitor. However, critics of stock options warn that they can encourage executives to follow strategies that might benefit the stock price in the short term but could be detrimental to the company in the long term.
