What Are Employees Stock Options?
Employee stock options (ESO) are a form of equity compensation offered to employees by a corporation.
More specifically, a corporation grants stock options to employees as an incentive to help build the value of the company, which in turn increases the value of the granted options.
Typically, the employee's right to exercise a portion of their options (buy the underlying shares) increases with time. This is referred to as a vesting schedule -- where the percentage of options the employee can exercise increases with the length of time they remain an employee of the granting corporation.
To illustrate vesting, if an employee were granted 100 ESOs and after 1-year of employment they were considered to be 25% vested, the employee would then have the right to exercise 25 (100 x .25 = 25) of their ESOs. If they are 100% vested (fully vested), they would then have the right to exercise all of their ESOs.
When an employee exercises their options, they can buy the company stock at the predefined strike price, and then sell the purchased shares at the market price. The difference between the strike price and the market price is called the spread.
If the strike price of the underlying stock is less than the market value (negative spread), then there would be nothing to gain from exercising ESOs. Exercising the ESOs only makes sense when the strike price is below the market price (positive spread, or in the money options).
Important Points to Consider
This basic explanation of ESOs barely scratches the surface of all the types and intricacies of ESOs, so be sure to consult a qualified financial planner for expert guidance. In the meantime, here are a few important points to keep in mind.
- The financial gain realized when exercising ESOs is taxed as ordinary income.
- ESOs have no marketable value and are typically considered to be non-transferable.
- ESOs normally cannot be held after termination of employment.
- Study the Company Stock Options Plan carefully before taking a job just for the stock options, and certainly before exercising your options.