Everything You Need To Know About Employee Stock Options (With Examples)

Compensation packages can be tricky to understand. One increasingly common benefit, especially among start-up companies, is offering employee stock options. Once reserved for top-level executives, stock options are now being extended to all levels of employees.

You’ve probably heard stories about people getting rich overnight thanks to stock options, and while that certainly does happen, it doesn’t automatically mean that all stock options are created equal. We’ll cover what exactly employee stock options are, how they work, and help you arrive at an educated decision about their value.

What Are Employee Stock Options?

Employee stock options (ESOs) grant employees the ability to purchase company stock for a preset price at a predetermined time. The stocks are not given freely to the employee; they simply have the option to purchase them if they wish to. Think of ESOs as an offer of discounted stocks in the company.

The pre-set stock price is called the “grant price,” “strike price,” or “exercise price.” A company’s shareholders must approve a company’s decision to offer stock options, but, in general, employers have flexibility in choosing the grant price and quantity of stock options offered to employees.

Employee stock options have expiration dates, and if you leave the company before purchasing the stock, that expiration date may be foreshortened.

Overall, stock options can make up a significant proportion of your compensation plan. They are a commonly-offered benefit among start-up companies that don’t have the capital to offer competitive pay for top-talent. Instead, they provide the chance for a big payday later on in place of a bigger paycheck in the here and now.

How Employee Stock Options Work

There are a few steps and terms you need to know to fully understand how employee stock options work. Let’s break those down before we look at an example:

1. Sign an employment contract with ESOs. Your employer will offer you a set amount of stock options to purchase up to a certain amount of shares in the company for a preset price. You agree to these conditions when you sign your employment contract.

2. Wait for the “cliff”. ESOs typically have a “cliff,” which means the waiting period before you can exercise your options. Usually, companies will instate a one-year cliff, meaning you have to wait one year before you can take advantage of your options.

   If you leave your employer before this period, you lose your stock options, incentivizing you to hang around.

3. Understand the vesting period. In addition to a cliff, ESOs also have a vesting period (similar to 401(k)s). A typical arrangement is to have a four-year vesting period, meaning after four years, the employee has the option to purchase the number of stocks laid out in their employment contract.

   Options vest over time, so in the case of a four-year vesting period, you would have the option to exercise 25% of your options after completing your first year, 50% after your second year, etc.

   Depending on your contract, options then continue to vest, either monthly or annually. So in the case above, each month, you would have access to exercising an additional ~2% of your options each month, or 25% each year.

4. Exercise your options. Once a certain proportion of your options have vested, you can exercise them. Exercising your options just means that you’re actually buying stock in the company.

   Regardless of the company’s performance, the grant price (predetermined in your employment contract) remains the same. Your stock options have no inherent value until you exercise them.

   You have a few options when exercising your options:

   • Buy the stock. The one most people think of is simply purchasing the stock and holding onto it. When you buy company stocks, you still need to pay any commissions, taxes, or fees associated with the broker you use.

   • Sell the stock. You still have to buy the stock first, but nothing prevents you from immediately flipping it by selling it for the market price.

     Brokerages may front you the money for the initial purchase, so you don’t need to have a lot of cash on hand to exercise your option in this way. You walk away with the profits after paying any brokerage fees.

   • Sell some and keep some. If you want to hedge your bets and effectively pay nothing, you can opt to sell enough stock to cover the purchase price and any associated fees while retaining a portion of your stocks.

     It can be a win-win because you don’t have to put any money down, but you’re still invested in the company.

Note that stock options are only valuable if the grant price is lower than the market price of the stock.

In cases where the grant price is higher than the market price, your option is “underwater.” You have no reason to exercise your options because you’d be better off buying the stock on the market, like anyone else.

Employee Stock Options Examples

That’s all great from a theoretical standpoint, but it’s illustrative to examine a real example to get a better idea of how to make the most of your ESOs. Let’s take a look at Sara, a new employee at a start-up whose employment contract includes ESOs:

Employee Stock Options and Taxes

The money you make from stock options is not typically tax-free. First, let’s talk about two categories of stock options:

• Non-qualified stock options (NQSOs). These are the most common type of stock options and the ones we’ve been discussing. The federal government does not give special tax treatment to NQSOs.

• Incentive stock option (ISOs). These are typically given to high-level executives and receive special tax treatment from the federal government.

For the stock options we’re talking about (NQSOs), the federal government treats any profits as regular income. Your company will report your income from exercising options on your W-2.

So if you chose to exercise your option by selling it to earn a quick $2,500, that money would be taxed. It’s technically a “short-term capital gain,” but it amounts to regular income tax.

However, if you hold onto your shares for a year or more, your tax burden is lower. That’s because you’re paying taxes on “long-term capital gains.”

Final Thoughts

Stock options are a nifty yet risky perk that employers can use to incentivize employees. After all, you’re a (potential) shareholder who has a direct impact on the company’s value.

It’s crucial to take expected compensation through stock options with a grain of salt. Start-ups use them to make up for their less-than-stellar salary offerings, so you’re taking an immediate pay cut with the hope of a big payday down the road.

But in the meantime, that stock could crumble, either due to failures within the company or a widespread economic downturn. You might also not stick around long enough to exercise your options or arrive at a point when exercising them would actually net you a profit.

Stock options could be your golden ticket or a worthless part of your compensation package, so be sure to vet the company in question and come to your own conclusions. There’s no right or wrong answer to accepting a job with stock options.

Still, we advise against working for a company you’re not excited about if you’re only in it for the potential payoff years down the line.

Author

Matthew Zane

Matthew Zane is the lead editor of Zippia's How To Get A Job Guides. He is a teacher, writer, and world-traveler that wants to help people at every stage of the career life cycle. He completed his masters in American Literature from Trinity College Dublin and BA in English from the University of Connecticut.