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Summary: Along with general benefits and perks, employee stock options can be an attractive offering to those who wish to create future wealth through investing in their employer company.
In an effort to offer more competitive compensation to employees, public businesses often provide stock options for employees. Along with general benefits and perks, employee stock options can be an attractive offering to those who wish to create future wealth through investing in their employer company. Learn more about stock options for employees in this article.
What are stock options for employees?
Stock options for employees is a compensation program that provides eligible employees with the opportunity to claim a limited number of stock options during special periods each year. In addition to other forms of compensation, which can include salaries and wages, bonuses, commissions, health insurance, retirement savings, and more, stock options for employees can be a valuable perk. Research shows that 92% of American workers surveyed by Propeller Insights on behalf of EquityBee said, “receiving stock options increases their sense of belonging to a company.”
Employees often choose this method to invest in the future success of their employer as well as take advantage of certain tax shelters.
There are two main types of employee stock options for employees, which include:
- Incentive stock options or ISOs: These are also called qualified or statutory stock options. ISOs are offered to upper management and key-level employees, who receive preferential tax treatment. The Internal Revenue Service (IRS) looks at ISOs as long-term capital gains, which provide some tax benefits.
- Non-qualified stock options, or NSOs: These are also called non-statutory stock options. They can be granted to all employees regardless of their level in the company, including board members and consultants. The IRS taxes profits made on NSOs as ordinary income.
How do employee stock options work?
If you are considering employee stock options, it’s important to know how they work. There are specific rules and guidelines that must be followed by both employers and employees. These rules are designed to prevent financial fraud and to help employees make the most of this benefit.
Offering stock options to employees provides them with the chance to own equity in the company. As a form of compensation, stock options are often used by start-ups and growing companies to boost their value in the stock market while simultaneously generating employee support.
A stock option offered to employees is referred to as a “strike price,” as eligible employees may buy a limited number of shares at a determined price. The strike price starts at 85% of the stock’s fair market value at the time it is granted unless a few unique events happen:
- Beneficiaries can accept cash or stocks if an eligible employee dies.
- Employees may also purchase or exchange stocks upon disability or retirement.
- When there is a corporate ownership exchange.
This must happen during an “exercise window,” a specific time-frame when employees can take this option.
Under government guidelines, eligible employees must be partially vested in the company, which equates to a period of time that they’ve worked for the company. This can be as little as 25% vested after working for the company for six months. Each company must determine its own vesting schedules.
Unlike standard or exchange-traded stock options, it is important to note that employee stock options cannot be sold. This is because the company offers stock options, not the actual stocks themselves, during the exercise window. Employees are required to sign an employee stock option agreement stating that they understand this.
Here’s the reason why employee stock options are so attractive. If the price of the company’s stock (offered to the public) rises above the exercise price, then and only then may participating employees obtain the company’s stock at a discount from other investors. Employees will have the option to sell the stocks on the market for a profit, or they may take their chances and hold onto the stocks over time to see how they perform in the market.
Why offer stock options for employees?
Before offering stock options for employees, there are some advantages and disadvantages to consider. From the employer side, stock options for employees help to raise capital for the company to support growth initiatives. On the flip side, employees benefit from having pride in future ownership of their company. They are allowed an opportunity to buy stock options at a lower rate than the initial public offering (IPO) and subsequent stocks offered on the open market. Once the stock is purchased by employees, they save around 15% or more of the cost of the stock at the fair market price.
There are additional benefits of offering stock options for employees. Employees who are thinking about retiring wealthy may have confidence in their company’s ability to generate solid revenues. They view the stock option as a valuable benefit and an opportunity to invest in the future success of their employer. The stocks are a tangible asset they can take with them when they move to other careers, but they are still connected by equity to the success of the employer. There is the potential to enjoy significant tax savings by investing in company stocks and profits if their actual shares are sold at a higher rate as the value increases.
Equity compensation plans, such as ESOs, can provide additional benefits. They are often used in recruitment to “sweeten the deal” and have been popular with candidates entering start-up organizations. Start-ups often don’t have the means to offer expensive benefits and generous salaries, but they can offer equity in their company as it grows. Employees can feel important and that their financial future looks healthy.
Simultaneously, the immediate impact of offering employee stock options is experienced as employees are more engaged in their work. They have a vested interest in bringing in profits as they know they will be able to cash out their stocks when this happens. Employers can also get a jump-start on generating much-needed funding when they go public with their stocks. More established businesses have a steady supply of foundational investors to help maintain a healthy price point. For those business owners who hope to flip the business once it gets profitable, stocks offer this option as their unrestricted shares can quickly be transferred or sold.
How to setup and manage stock options for employees
Establishing a stock options plan for employees is relatively simple. Use the following steps to get started:
1. Determine the stock options incentive
Align your ESO plan with the company’s mission and values. Work with your board of directors, founders, and trusted advisors to determine how you will communicate the ESO value to employees and how much of the company will be shared with them.
2. Document and seek legal guidance
Carefully write everything down to ensure the ESO plan is documented. Get a qualified corporate attorney to review any plans you have, such as when you will release stock options and to whom, providing purchase dates, setting the initial price, and more. Remember that you may offer different ESOs based on different criteria, such as years of service, new hire status, or level within the company.
3. Communicate your ESO plan
Once you have an approved plan to offer stock options, your next step is to communicate this plan to all eligible employees, providing plenty of education. Your business may find this challenging due to the changing needs of the workplace. A survey conducted by Carta indicated that “69% of employees think it’s important for their company to help them understand how their equity works.” Make sure you roll out the employee stock options program using a central digital platform, much like your benefits enrollment does. Focus on highlighting the benefits of participating and state important dates for employees to pay attention to. Include a clearly written policy in your employee handbook.
4. Maintain compliance with your ESO plan
Employee stock options can come with complex rules set forth by government agencies. To protect the organization against mismanaged plans, take the time to secure employee professional liability (EPL) insurance and directors and officers (D&O) insurance. Use equity management software that is current with IRS rules regarding cap limits.
Disadvantages of Stock Options for Employees
While there are many benefits to offering stock options for employees, there are also some potential drawbacks to consider. For employees, stock options can be risky, as the value of the stock may not increase as expected or may even decrease. This can lead to employees feeling like they’ve wasted their money or missed out on other investment opportunities. Additionally, stock options can be complex and difficult to understand, which can lead to confusion and frustration among employees.
For employers, offering stock options can be expensive and time-consuming to set up and manage. There are also legal and compliance issues to consider, as well as the potential for dilution of ownership if too many stock options are granted. Additionally, if the company’s stock price doesn’t perform as expected, it can lead to decreased employee morale and retention.
Conclusion
Stock options can be a valuable form of compensation for employees, providing them with a sense of ownership and the potential for financial gain. However, it’s important for both employers and employees to carefully consider the advantages and disadvantages before deciding to offer or accept stock options. By understanding how stock options work and the potential risks and rewards involved, companies can make informed decisions about whether stock options are right for them and how to set up and manage an effective employee stock option plan.
FAQ
A stock is the actual part ownership in a company that changes with the performance of the business, with earnings rising and falling over time and stock market changes. A stock option is the opportunity to purchase stocks at a later date based on company-decided criteria.
A standard stock option plan for employees gives them the right to purchase stocks over a 4-year period so they can take advantage of stock revenues when the time is right. Some plans restrict stock purchases for 12 months, but then the employees can invest in 25% of the stock options the employer authorizes.
Andrew (Drew) joined the Remote People team in 2020 and is currently Director, Regulatory Affairs. For the past 13 years, he has been a trusted advisor to C-Suite executives and government ministers on international compliance and regulatory issues. Drew holds a law degree from the University of Otago, a PhD from the University of Sydney, and is an enrolled Barrister and Solicitor of the High Court of New Zealand.
