Employee stock options (ESOs) are a form of equity compensation granted by companies to their employees and executives. Like a regular (call) option, an ESO gives the holder the right to purchase the underlying asset – the company’s stock – at a specified price for a finite period of time. These terms (also defined in greater detail in Chapter 2) and conditions are spelled out in the Employee Stock Options agreement.
In this Tutorial, we compare ESOs to listed (exchange-traded) options, explore the basics of ESO valuation, and evaluate the risks and rewards associated with holding ESOs during their limited life. We also examine the pros and cons of early exercise of ESOs. (Related: Get The Most Out Of Employee Stock Options)
What is an equity compensation plan anyway? As the term suggests, it provides financial compensation or remuneration to a company’s key internal stakeholders – its employees, executives and in certain cases, Directors – through a share of the company’s equity.
ESOs are not the only form of equity compensation, but they are among the most common. Other types of equity compensation plans include:
- Restricted stock grants – these give employees the right to acquire or receive shares once certain criteria are attained, like working for a defined number of years or meeting performance targets.
- Stock appreciation rights – SARs provide the right to the increase in the value of a designated number of shares; such increase in value is payable in cash or company stock.
- Phantom stock – this pays a future cash bonus equal to the value of a defined number of shares; no legal transfer of share ownership usually takes place, although the phantom stock may be convertible to actual shares if defined trigger events occur.
- Employee stock purchase plans – these plans give employees the right to purchase company shares, usually at a discount.
In broad terms, the commonality between all these equity compensation plans is that they give employees and stakeholders a monetary incentive to build the company and share in its growth and success. The major difference lies in the taxation aspect of these plans, a subject that is beyond the scope of this Tutorial.
For employees, the key benefits of an equity compensation plan are:
- An opportunity to share directly in the company’s success;
- Pride of ownership; employees may feel motivated to be fully productive because they own a stake in the company;
- Provides a tangible representation of how much their contribution is worth to the employer; and
- Depending on the plan, it may offer the potential for tax savings upon sale or disposal of the shares.
The benefits of an equity compensation plan to employers are:
- It is a key tool to recruit the best and the brightest in an increasingly integrated global economy where there is worldwide competition for top talent;
- Boosts employee job satisfaction and financial wellbeing by providing lucrative financial incentives;
- Incentivizes employees to help the company grow and succeed because they can share in its success;
- May be used as a potential exit strategy for owners, in some instances.
In terms of stock options, there are two main types:
- Incentive stock options (ISOs), also known as statutory or qualified options, are generally only offered to key employees and top management. They receive preferential tax treatment in many cases, as the IRS treats gains on such options as long-term capital gains.
- Non-qualified stock options (NSOs) can be granted to employees at all levels of a company, as well as to Board members and consultants. Also known as non-statutory stock options, profits on these are considered as ordinary income and are taxed as such. This Tutorial focuses on non-qualified stock options.
Note that Employee Stock Option Plans should not be confused with the term “ESOP,” or Employee Stock Ownership Plan, which is a qualified retirement plan. While ESOPs also have the objective of aligning the interests of an enterprise’s employees and shareholders, they have different characteristics and nuances that are not covered in this Tutorial (find more on ESOPs here).
ESOs are held by millions of employee and executives in North America and worldwide. Although trying to get a handle on their risks, from both a tax and equity perspective, is not easy, a little effort at understanding the fundamentals of ESOs will go a long way toward demystifying them. This knowledge should enable you to have a more informed discussion with your financial planner or wealth manager, and hopefully empower you to make sound decisions about your financial future.