How Do Employee Stock Options Work? (Types of Options, Taxes, and More)

A stock option is one of the most common types of employee equity compensation. It is a contract that enables an employee to purchase a given number of shares of a company at a determined price referred to as the strike price and within a specified time-frame called the exercise window.

Notably, employee stock options are not actual shares. They are an opportunity for employees to exercise (purchase) a specified amount of company shares at an agreed-upon price (the strike price) with the hope that they will sell their purchased shares for a higher price than they paid for.

Read on to understand the most common types of employee stock options, plus advice on taxes and establishing a strategy for your company.

How Do Employee Stock Options Work?

A company typically awards stock options through grants. Your grant provides all details of your equity plan, including how the company will award the equity compensation.

It may include crucial details such as:

• The grant date (this specific date when your stock options are granted to you)
• The number of options that are granted to you
• The type of options granted
• The strike price/exercise price (this is the price you will pay to buy the options)
• Vesting schedule (the period when you gain rights to exercise your grant of stock options)
• The exercise window (employees typically exercise options only during a fixed period, usually lasting between 7 to 10 years while still under employment)
• The expiration date (fter this date, you will no longer have the right to exercise)
• The details of your options on the effects of termination of employment and any possible change of control of the company that you have vested

Notably, before you earn the right to exercise, your stocks have to vest first. Vesting means you have to work for a company for an agreed period if you want to become an owner. Once your options vest, you gain the ability to exercise them. This means that you can now buy shares of the company's stock. Unless you exercise, your options won't have any real value.

Essentially, the rules that guide and regulate stock options are imposed by a company's discretion and existing tax and securities laws of a given jurisdiction. Employees considering stock options should familiarize themselves with their equity agreements before signing agreements regarding their stock options.

Types of Employee Stock Options Available For Employees

The two main types of stock options are incentive stock option s (ISOs) and nonqualified stock options (NSOs). The primary difference between the two stock options lies in how the stock options are taxed.

Incentive Stock Options (ISOs)

With ISOS, you typically qualify for special tax treatment when you hold onto your shares for a specified period, usually a minimum of one year after exercising and two years after your grant date. This means that you won't have to pay taxes on the exercise date. However, you may be required to pay alternative minimum tax (AMT) if you fail to sell your shares within one year after you exercise them. You must also pay regular income taxes if sold before then.

Nonqualified Stock Options (NSOs)

This option requires you to pay taxes both when they exercise and sell. They are typically taxed as regular income and require the difference between the stock's market value and the exercise price. With this option, you will have to pay short-term capital gains on shares that you sell within one year of the exercise date, as well as long-term capital gains on shares that you sell after at least one year.

Additional Types of Equity Compensation

Restricted Stock Units (RSUs)

Restricted Stock Units (RSU) is another type of compensation issued to an employee in the form of company stock or shares. The restricted stock units are typically administered via a vesting plan and a specified distribution schedule that stipulates the performance milestones that an employee must achieve or an agreed length of time upon which an employee has to remain with their employer. Although RSUs give employees interest in company shares, they typically don't have real value until vesting is complete. Once they vest, they are considered income, with a portion being withheld to cover income taxes. The employee can sell the remaining shares as they wish.

Employee Stock Purchase Plans (ESPPs)

An Employee Stock Purchase Plan (ESPPs) is a company-run program that allows employees to purchase company stock at a discounted price which can be as much as 15% lower than the market price. As an employee, you contribute to the plan via payroll deductions lasting from the offer date to the purchase date. At the purchase date, the company uses your accumulated funds to buy a specified number of stocks in the company on your behalf.

Performance Shares

As the name suggests, performance shares are shares of stock granted to employees once they achieve predetermined performance objectives over a given period. They are incentive-based forms of stock compensation meant to drive employees of a company to achieve specific benchmarks. Performance shares are usually granted if a company achieves particular metrics, for example, if the company's stock attains a desired value on the market or if the management team completes a campaign or project within a specified deadline.

How to Create an Employee Stock Option Plan: 4 Steps

If you are a C-suite leader, considering adding an employee stock option to your compensation plans, use the following steps to get started:

Step 1: Set Up

Determine the best way to balance cash and equity compensation. Next, adapt your stock plan and option agreements before seeking approval from the stockholder and the company board. At this point, you should also acquire all the relevant permits and certifications from the concerned regulatory bodies.

Step 2: Maintenance

This step focuses on all the items that you must monitor on an ongoing basis. In essence, you must establish a method to keep your valuation up to date. Determine the number of stock options needed for new hires and establish a robust stock option pool.

Step 3: Making Offers

This step focuses on an ideal checklist that you will use to make a prospective employee an option grant.

The checklist should cover essential items such as budget, confirmation of employee details, and the grant size. In a nutshell, you should ascertain that you have adequate allocated shares to offer new employees to avoid future legal problems. You should also confirm the legal status of the prospective employee before making an offer.

Finally, when offering the grant, state that the terms of shares are subject to board approval.

Step 4: Finalizing the Grant

Have an expert re-evaluate the 409A to ensure it is free of errors and seal loopholes. You should then ask the board to approve the employee's stock option grant. Once this is done, process and execute the agreement before you finally update the company cap table.

Should I Exercise My Stock Options?

Generally, it's best to wait for the company to issue an initial public offering (IPO), assuming there are plans for the company to go public. Even after the company goes public, you should wait for the stock market price to rise above your exercise price before you exercise your options.

If your company has no immediate plans to go public, it is best to wait for indicators that point to a climbing stock price before you exercise your options.

Finally, if you're facing a dilemma and are unsure of how to proceed, it's always best to talk to an experienced tax advisor who can help you figure out the best time to exercise.

What Are the Tax Implications of Exercising Stock Options?

Ideally, you have to pay taxes once you exercise or sell your stock options. The amount of tax you pay depends on the type of options you have and the length of time between exercising and selling.

If you exercise options and sell within one year of the exercise date, you must report the transaction as a short-term capital gain. This form of capital gain attracts the regular federal income tax rates.

If you decide to sell your shares after one year of exercise, the sale is considered a long-term capital gain that attracts lower tax rates than the regular rates. This implies that holding your shares for at least one year can help you save money on taxes.

Next Steps: Will You Offer Employee Stock Options?

Undoubtedly, an equity compensation plan is a valuable part of a company's employee benefits. From the company's perspective, equity compensation plans offer employers alternative ways to incentivize their employees without hurting their bottom line. It also aligns the employee's self-interest with the company shareholder's self-interest.

Additionally, equity compensation helps a company attract and retain highly talented employees. From the employee perspective, equity compensation provides investment opportunities with no downside risks. It also offers several tax benefits.