What Are Employee Stock Options and How Do They Work?

Businesses that offer employee stock options as a perk incentivize staff from the top down to commit to their roles. It’s a unique type of employee bonus because the amount of money it carries is entirely dependent on how well the company performs in the market.

Here we'll go over everything you need to know about employee stock options.

What Are Employee Stock Options (ESOs)?

Employee stock options are a type of contract that allows employees to buy shares of company stock at a pre-set price over a finite time period. Globally, similar benefits may be referred to as Employee Share Plans, Company Share Option Plans, Enterprise Management Incentives, and more. The circumstances regarding such agreements are contingent on local regulations and employment agreements.

In the U.S., most ESO packages are associated with start-up companies that want to incentivize continued growth and employee retention. Since employees do not receive their stocks immediately and cannot cash in,  they must stay with the company in order to reap the benefits. Furthermore, the ESO is usually canceled if the employee leaves before the exercise price is reached.

Benefits of Offering Stock Options to Your Employees

Offering stock options to employees has a number of benefits associated with it, including, but not limited to:

• Owning a piece of the business: Receiving stock options means that employees have shared ownership of the business. This personal and financial stake in the performance of the company incentivizes them to align with business goals and work hard to achieve them. After all, the better a company performs, the more return they'll make in the long run.
• Enhanced talent acquisition: ESOs are a highly attractive benefit for potential candidates. In fact, many employees have come to expect stock options as a basic benefit, rather than something novel. This is particularly true within product development. Because of that, offering share options can enable you to attract and hire the best talent.
• Increased employee retention: Once you’ve secured top talent, share options can be a good way of retaining them for longer. This is because employees can’t cash in on stock options immediately. Instead, they must wait until the stock price reaches a certain point. What’s more, stock options are often canceled if the employee leaves before that point. This means employees are incentivized to stick around in their role and facilitate growth.

How Do Employee Stock Options Work?

Typically, the employee will first sign the ESO, which will stipulate when they can buy company stock. This usually occurs once the share price exceeds the exercise price (i.e., the established price at which shares may be bought). Once this happens, the employee receives company stock at a discounted price, at which point they may sell it for a profit or hold onto it indefinitely in the hopes that the price will further increase.

Most ESOs are granted on companies that are publicly traded, however private companies can design their own ESO-adjacent programs to make up for other lacking global employee benefits or lower salaries, or implement an ESO program prior to an initial public offering (IPO).

Types of Employee Stock Options

Here are the two main types of employee stock options of which you should be aware:

Incentive Stock Option (ISO)

Also referred to as qualified options, ISOs are strictly offered to certain valuable employees and top management. They are your typical stock option, being issued when the terms of the ESO is fulfilled, at which point the employee is free to sell or hold onto the stocks.

In some jurisdictions, ISOs have tax benefits as well. In the U.S., for instance, the Internal Revenue Service (IRS) does not tax ISOs when they are exercised (i.e., when you purchase the stock at the set price.) It will, however, tax the sale of said stock.

Non-qualified Stock Option (NSO)

NSOs may be granted to any employee in the company, including consultants, advisors, and board members. They operate the same way as ISOs, but they are not subject to the same tax benefits as ISOs. In the U.S., the IRS taxes NSOs at normal income tax rates.

How to Set Up Stock Options For Your Employees

Here are some tips on how to set up stock options for your employees:

1. Pre-Planning

Before you dive in, consult with the company founders, advisors, and board of directors in order to develop your company's philosophy, which will drive the success of any employee stock option strategy. Here are just a few things to consider:

• How much of your company are you willing to share with both early and later employees?
• How standardized should grants be?
• How will you balance cash and equity compensation?

2. Get It in Writing

Once the business' key stakeholders solidify the company philosophy surrounding the employee stock ownership plan (ESOP), it's time to nail down the details. Formalize the plan by writing it down and then getting it approved by the board of directors, lawyers, and other advisors. The key here is to ensure your ESOP is compliant with local regulations (where all employees are located) and is mutually beneficial to both the company and its employees.

3. Employee Stock Ownership Plan Maintenance

It's not enough to solidify and formalize your ESOP; you must also maintain it. Stay on top of your valuation. In the U.S., for example, this is called a 409A valuation and helps you determine your ESO's exercise price, which will affect when an employee can actually buy shares. The 409A valuation must be compliant with IRS regulations and will change every 12 months or when significant financial milestones are achieved.

You'll also need to create and maintain an equity budget. Be sure to keep in mind that you will have to set aside stock options for future hires.

4. Offer the ESOs

Here are some basic steps to take when offering an ESO to employees:

• Confirm you have enough unallocated stock options to cover your offer. Failing to do this may open you up to litigation.
• Ensure the employee is legally allowed to receive stock options. This is dependent on where they live and the local labor laws they are subject to.
• Provide an offer letter to the candidate, as approved by the board of directors.

Once you’ve finalized your ESOP, make a formal announcement to your employees, informing them of the plan’s details. Make sure it’s easy to review the plan details and sign up for and manage a plan through your HR system.