Employers offer many forms of compensation besides cash, with employee stock options being a popular choice. Instead of issuing shares directly, employee stock options allow workers to purchase shares of their company at a given price within a certain time frame. While this can be a valuable benefit for employees, there are benefits and drawbacks to consider. That will be important when evaluating stock options during the job application process.
What are employee stock options?
Employee stock options (ESOs) are a form of compensation employers offer to their employees. Often, startups offer ESOs to attract top talent. It allows employees to capitalize on future growth via their ownership of shares, and startups offer them because they may be cash-strapped. Large, established companies also frequently offer ESOs to employees.
If your employer has an ESO program, it usually allows you to purchase shares of company stock at a pre-determined price for a limited time. However, not all of the ESOs may be available to purchase at once; companies commonly use vesting schedules. The ESO’s pre-determined price is called the strike price, typically the fair market value of stock when the ESO is issued.
Because the strike price is set in advance, the fair market value of the stock could be higher (or lower) than the exercise price. If the fair market value is higher, the ESO will give you a good deal. But if the fair market value is lower, you’ll be paying more than the market has determined the stock is worth. It’s a good idea to check the fair market value of the stock before exercising your stock option.
There are two primary types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). ISOs are generally only offered to employees and may receive favorable tax treatment if held for a specific period. NSOs can be offered to a wider range of people, including third-party contractors. However, they don’t receive favorable tax treatment.
Benefits and drawbacks
Employee stock options are a unique arrangement with several potential benefits and drawbacks. The most obvious benefit is the potential financial reward for employees if the company does well. If the strike price is set at a low point and the fair market value of the stock grows exponentially, employees exercising stock options could fare extremely well.
From the employer’s perspective, this dynamic can also make ESOs attractive. Because the company’s success could allow employees to make a substantial return, it means they have a vested interest in the company. This, in turn, could make employees more motivated and work harder. It can also increase morale and put employees and management on the same page.
Similarly, ESOs can reduce turnover at companies. It takes time for share prices to rise, so employees can benefit from staying at the company longer. As previously mentioned, ESOs only allow employees to exercise their stock options for a limited time, so this won’t keep employees around forever. Still, it can increase retention to a degree. Furthermore, vesting schedules may make workers more inclined to stay so that they’re able to exercise their options when they vest.
The biggest drawback of ESOs is they don’t guarantee the company will grow along with its share price. If the fair market value of the company’s stock stays flat or even declines, the stock option has no value since employees could simply buy shares of stock at an equal or lesser price.
Another drawback could lie in holding a significant amount of your wealth in stock options. In this case, both your salary and a large portion of your investments rely on the same company. This can be a significant risk for employees, especially if the employer goes belly-up.
A potential restriction on ESOs
Although ESOs can be an appealing choice for employees and employers alike, they may be restricted by a vesting period. The vesting period is the time you must wait before you can exercise your stock option. The length of the vesting period varies by employer but can be one year or longer. Some employers may use performance-based metrics to determine vesting eligibility.
How to evaluate employee stock options
Employee stock options can offer significant growth potential, especially if you are getting in on the ground floor of a promising startup. However, evaluating an ESO before accepting it is important. You should start by asking yourself questions, such as:
- What is the company’s growth potential?
- How competitive is the offer compared to industry standards? How many shares are being offered, and what is the vesting schedule (if there is one)?
- Does the company have a competitive advantage over similar businesses in the industry?
To answer these questions, consider factors like the company’s financial performance, its position within the industry and its outlook for the future. It may be difficult to know the company’s financial performance if it isn’t public, but it may have provided some clues along with the ESO documentation. If it hasn’t provided those details, compare the business to competitors for an idea of its advantages.
You must also review all the details of the ESO. This includes the grant date (when you receive the stock option), strike price and vesting schedule. Also, check the expiration date, which determines how long you have to exercise your stock options after they vest.
You should also consider the tax implications. Incentive stock options have tax advantages, but non-qualified stock options do not. If you have an NSO, selling your shares may be taxable. In particular, the difference between the strike price and the fair market value is your “income,” which may be taxable. If you have an NSO, consider meeting with a tax professional to understand the tax implications of selling your shares.
Bottom line
Employee stock options give employees the right to purchase shares at a pre-determined price for a certain period in the future. This can be a useful way for businesses to attract top talent and gives employees the potential to capitalize on future company growth. But it also creates risks for workers if the company’s share price doesn’t grow over time. Employees must carefully evaluate all the details of an ESO before deciding whether the offer is worth considering.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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