What are Employee Stock Options (ESOs)?

More and more companies are offering stock options as part of the compensation package when recruiting new talent.

Employee Stock Options are a type of equity compensation that companies can grant to their employees. Instead of giving the stock directly, the company awards derivative options on the stock.

These are regular call options that give the employee the right to buy company stock at a set price for a specified period.

The Employee Stock Options terms can either be a part of an employee stock options agreement or included in the employment contract itself.

Equity Compensation

Employee stock options are one form of equity compensation we can offer our employees. Other types can be:

  • Stock Appreciation Rights (SARs);
  • Restricted Stock Grants;
  • Phantom Stock.

All equity compensation plans give employees an incentive to grow the business and subsequently share in its success.

This article will focus on Employee Stock Options (ESOs), look at what they are and how they work.

What are Employee Stock Options?

Employee Stock Options are a form of alternative compensation. Companies can use them to attract employees to work for a lower-than-normal salary. ESOs help businesses attract talent that believes strongly in the company’s future success.

We usually associate employee stock options with start-up businesses. Such companies reward early employees for believing in the company in the form of optional stock holding. As a strategy, it can also help incentivize high-value people to stay with the company for longer.

ESOs give employees a potential benefit to realize if the stock price rises above the options’ strike price. We can then exercise the options and acquire company stock at a discount. There are two options then – we can sell the stock for profit or hold it for the future if we believe its value will increase.

In an Employee Stock Options agreement, the employee is the grantee, and the employer is the grantor. The grantee receives the equity compensation in the form of ESOs, which have certain restrictions.

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Employee Stock Option Agreement

The document which awards equity compensation from a company to the employee is the Equity Grant Agreement. It is crucial to familiarize ourselves with the document before taking any action to exercise ESOs.

ESO agreements contain some essential aspects of the offered options:

  • Grant date;
  • The vesting schedule;
  • The strike price;
  • Expiration date;
  • Exercise window.

The grant date is when the options start to vest. Once they become vested, the employees can exercise them.

Vesting of ESOs

One of the most important details of an ESO agreement is the vesting period.

It represents the length of time an employee has to wait before exercising their options and acquiring company stock.

Options typically vest in chunks over time. The vesting schedule shows how this happens. A standard vesting structure is a four-year vesting period with a one-year cliff. This means 25% of the ESOs vest after one year of employment, and the rest vest proportionally over the next three years, every month. If we present this in a chart, it will look something like this.

employee stock options

It is common to have additional restrictions to ensure employees don’t immediately sell their shares and leave the company.

Reload Option

Some Employee Stock Option agreements have a reload option. This means the employee can get additional options once they exercise their vested options, giving a higher incentive to convert options to stock holding.

Exercise Employee Stock Options

When options have vested, employees have the right to exercise them and purchase company stock. However, in some instances, employees may not have the cash to exercise the options. There are two approaches they can take in such a situation:

  • Exercise and sell – an employee can use a brokerage firm to front them the money to acquire the company stock and then sell the shares. The brokerage firm will then deduct the fronted amount and pay the balance to the employee.
  • Exercise and sell to cover – an employee uses the brokerage firm to buy the stock and then sell enough shares to cover the cash used to exercise the options. The employee receives the remaining stock shares.

Options are not indefinite. Employees are usually restricted in their right to purchase stock by an expiration date attached to their options. Commonly, this is ten years from the grant date.

Employment Termination

If an employee leaves the company or their contract is terminated, they can only exercise the already vested options. Usually, there’s a shortened period to do so, called the post-termination exercise (PTE) period.

Value of ESOs

Employee Stock Options are only valuable if the stock price increases above the ESO exercise (strike) price. Otherwise, it’s best to let them expire.

The value of a stock option consists of two elements – its intrinsic value and its time value.

The time value of ESOs is hard to calculate as they don’t have a market price. Commonly we would use a theoretical pricing method like the Black-Scholes option pricing model to estimate the fair value of Employee Stock Options.

If an option is “at the money,” it means the stock’s market price is equal to the option’s exercise price. If it is “out of the money,” the stock’s market price is below the option’s exercise price. In these two cases, the intrinsic value is zero, and the option only has a time value.

employee stock options

Employee Stock Options value fluctuates over time based on the underlying stock value and the volatility in model assumptions.

Let’s look at an example where ESO’s are “out of the money,” and the underlying stock’s market price is below the exercise price for the options. Then the total fair value is the time value.

employee stock options

In the above example, the ESOs are “out of the money,” the intrinsic value is, therefore, zero, and the total value remains time value.

In such a scenario, it’s not logical to exercise the options. It’s cheaper to buy stock instead. Also, if we exercise, we will be losing the time value of the ESOs.

The significant assumptions that impact the fair value of Employee Stock Options are:

  • The volatility of assumptions;
  • Time to expiration;
  • The risk-free rate of return;
  • Underlying stock market price.

Nonqualified and Incentive stock options

These are the two types of Employee Stock Options a company can award to its employees. The significant difference between these variations comes from the way they are treaded for tax purposes.

When we exercise Nonqualified (or non-statutory) stock options (NSOs), the difference between the strike price and the market price is the amount we pay taxes on. These are usually withheld and paid by the employer.

Incentive Stock Options (ISOs), on the other hand, qualify for special tax treatment, which means the exercise transaction is not taxed. Generally, if we hold such options for a more extended period, they can fall into a more favorable tax category.

ISOs have other requirements. For example, in the United States, the IRS says if granted ISOs are above $100 thousand, we should treat the excess portion as NSOs.

These requirements largely depend on the local tax legislation, so it is a good idea to talk to a tax consultant in such circumstances.

Benefits of Employee Stock Options

Providing equity compensation to employees has benefits both for them and for the employer.

Some of the most notable advantages ESOs give to employees can be:

  • Owning a stake in the business offers employees a better sense of connection;
  • ESOs show how much employees’ contribution is worth to the employer;
  • Employees can share in the company’s success through their equity holding;

There are also benefits to the employer deciding to offer an Employee Stock Options plan:

  • It’s a more attractive compensation package and helps to recruit top talent;
  • ESOs are a cost-effective benefit;
  • Increases job satisfaction for employees and decreases the churn rate;
  • Higher engagement from employees in terms of growing the business.

ESOs Disadvantages

Offering Employee Stock Options can also have some negative implications:

  • It’s a more complex option for employees in terms of tax;
  • It isn’t easy to value ESOs;
  • If other employees are not as invested in the company’s growth and success, this can lead to conflicts within the team;
  • In the long run, the dilution of equity can become very costly to the shareholders.

Conclusion

Employee Stock Options (ESOs) are not as straight-forward as a monthly salary, but they hold the potential of a significant payday in the future. It is important to remember that options give the right to acquire company stock, but there is no obligation to exercise them.

To protect the company’s interest, ESOs have a vesting period, which means employees have to earn the stock options over time.

Dobromir Dikov

FCCA, FMVA

Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.

In my spare time, I am into skiing, hiking and running. I am also active on Instagram and YouTube, where I try different ways to express my creative side.

The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of Magnimetrics. Neither Magnimetrics nor any person acting on their behalf may be held responsible for the use which may be made of the information contained herein. The information in this article is for educational purposes only and should not be treated as professional advice. Magnimetrics and the author of this publication accept no responsibility for any damages or losses sustained in the result of using the information presented in the publication.

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