What are Employee Stock Options (ESOs)?

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Definition:

Employee stock options (ESOs) allow employees to buy a predetermined number of shares in the company stock at a price that’s arranged in advance.

🤔 Understanding employee stock options (ESOs)

Employers can offer employee stock options (ESOs) as a perk of employment. If a company gives you a stock option, you aren’t getting the actual shares. They’re giving you the opportunity to buy shares of stock in the future. The purchase price of each share is determined ahead of time, and there may be a limit on how many shares an employee can buy. ESOs can also specify an expiration date. If you want to purchase stock, you must exercise your right before the ESO expires. A company can offer two types of stock options, an incentive stock option (ISO) and a nonstatutory stock option (NSO). Some employers may require you to be vested, or employed for a specific period of time, before you can purchase the stock.

Example

Imagine you get a job at a great new company. As part of the benefits package, your new employer gives you employee stock options for 10,000 shares of the company’s stock. The contract that outlines the terms requires you to be vested for three years before you can exercise (or buy) the purchase.

After three years, you can purchase the shares for the price that was set in the contract you signed. If the exercise price is $1, you need $10,000 to purchase all of your options. Once you exercise your rights and own the stock, you can keep it or sell it. If you hold on to the shares, you have a chance to make money if the price goes up. The share price could also fall, causing you to lose money.

If you sell your stock on the open market, the buyer will pay market value. Let’s say market value is $2 when you sell. Since you paid $1 per share when you exercised your stock options, you essentially double your money if you sell it for $2 a share (ignoring any transaction fees and taxes).

Takeaway

Employee stock options are like a coupon...

Buying shares with ESOs isn’t much different from using a coupon to buy bananas at the grocery store. They both set a predetermined price and have an expiration date. Like a coupon, you don’t have to use your stock options. You could wait for the expiration date to come and go, and the contract would be invalid. You could also use the option to buy shares at the pre-set price. If the stock prices are higher than the price set in your ESO, your ESO might produce a profit.

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What are employee stock options (ESOs)?

Employee stock options (ESOs) are an offer to an employee giving the right to buy shares in the company at a predetermined price. Employers can use ESOs as a recruitment tool in addition to traditional compensation to attract new employees.

A company can also issue stock options as a reward for current employees, which can align an employee’s interest with that of the company and its shareholders. They can seem complicated because ESOs don’t give you actual shares in the company. Instead, you get the option to buy them in the future.

The terms of the stock options are usually outlined in a contract between a company and an employee. Generally, all ESOs contracts limit the number of shares you can buy and set a grant price. A grant price is also known as strike price, and describes how much you pay for each share.

There are a few important dates to remember with an ESO.

The grant date is the date the company issues the options. Some companies include a vesting date that requires you to be vested before you can exercise your options. For instance, your ESO might say you have to be employed with the company for three years before you’re able to purchase the shares.

You can be vested gradually over time, such as 20% per year for five years, or all at once. If you vest all at once, it’s called cliff vesting.

When you take action to purchase stock, that’s called your exercise date. ESOs can also have an expiration date, called a maturity date. If you want to exercise your ESOs, you must take action before they expire.

How do employee stock options work?

While employers can issue ESOs with different vesting schedules and grant prices, they all generally work in the same way. If you get employee stock options, you have the right to purchase stock, but no obligation to follow through on the purchase.

Before exercising your right to buy stock, check the market price. If the current market price is higher than the grant price, you could get your shares at a discount. However, it wouldn’t make sense to buy shares if the grant price is higher than the market price.

For instance, if your ESO came with a grant price of $1.00 per share and had a market price of $0.75 per share, you would lose $0.25 on each share you bought.

If you want to exercise your right to options, you might consider paying with cash. Typically, you have three ways to purchase shares: Cashless exercise, cash purchase, and stock swap.

A cash purchase is a traditional method of buying stock through ESOs. You pay for the cost of the shares using money from a bank account or a personal loan. If you don’t have enough money on hand to cover the cost of the shares, a cashless exercise lets you buy stock using a short-term loan from the brokerage company. The brokerage company covers all costs of selling shares from your ESO. When the transaction is complete, they pay themselves back and send you any profit you might have made from the transaction.

Stock swaps are more complicated. If you already own shares of company stock, this might be a good choice. It allows you to use fair market value (FMV) of the stock already in your portfolio to cover the cost of your ESOs. Because a stock swap involves using shares you already own to pay for the new options, it’s best to work with a tax professional or financial advisor.

How can you get the most value from your ESOs?

With the right strategy, ESOs can be valuable, but they also may never pan out as intended. The shares could fund your future personal finance goals, such as buying a new home, paying for your children’s college, or padding your retirement savings.

Stock options can also be confusing, which leaves you vulnerable to making mistakes. You should take the time to understand the terms of your ESOs. They can be a significant part of your compensation package, but you must know the ins and outs to take full advantage. If you don’t understand how to fit stock options into your overall financial picture, asking a financial advisor can help you get the most value.

Taxes can have a huge impact on your choices. The tax treatment of your ESO depends on the type. ESOs can be an incentive stock option (ISO) or a non-qualified stock option (NSO). With an ISO, you get a tax advantage upfront. Instead of reporting the stock option as income when you exercise it, you wait until you sell the stock to pay income tax.

With an NSO, you pay the tax when you exercise your option. An NSO also requires you to report any long-term capital gains when you sell the stock.

One potential hazard of ESOs is if you make the mistake of putting all your eggs in one basket. If you concentrate your investment portfolio with company shares, you could suffer a significant loss if the stock price of your company crashes. For this reason, it’s often better to diversify your investments.

Additionally, since most options have a vesting schedule, make sure you know what happens if you leave the company. If you leave your employer, you may still have three months to exercise your right to buy vested stock options.

Which companies give ESOs?

Any publicly traded company can choose to offer stock options to its employees. In some cases, private companies may also offer ESOs.

Stock option plans are a popular benefit that companies can offer employees. Tech companies and startups are common types of businesses that have ESOs, a trend that picked up speed in the 1950s.

Some top companies provide the option to buy stock as part of their compensation package. For instance, GoDaddy, a provider of domain names and web hosting, cites rewarding results-oriented employees with stock options as a primary reason for the company’s growth.

What is an ESO vs. OTC stock?

Not all stocks are bought and sold in the open market through an exchange. Securities that aren’t listed on a stock exchange are called over-the-counter (OTC) stock. It includes stocks, debt securities, and derivatives. Derivatives base their value on the value of something else. Unlike securities you trade on an exchange, OTC stock doesn’t publicly list the prices of each share.

Companies that aren’t publicly held on an exchange can offer ESOs, but they’re not as popular. Without public stock, marketing the shares is difficult.

If a company issued ESOs with OTC stock, it would be run by a group of dealers on a decentralized network connected by telephones and computers to manage trades. The dealers on the network are called market makers and are heavily regulated by the Financial Industry Regulation Authority (FINRA).

What is a stock grant?

Employee stock options (ESOs) and stock option grants are similar. Companies can use both to reward employees or as part of overall compensation or salary. Despite their similarities, significant differences exist between the two.

If your employer gives you ESOs, you have the option to purchase shares of the company stock. Usually, the contract puts a limit on the number of stocks you can buy. The contract also sets the stock price ahead of time and includes an expiration date when the ESO expires. While ESOs can let you exercise your purchase right away or require you to be vested, stock grants — which give you stock, not just the option to buy stock — almost always require you to be vested before receiving shares.

Stock options are helpful in recruiting new talent to a company. If you’re a new hire and get an ESO to buy shares below market value, you can consider the difference between market price and the price you paid a potential bonus on top of your regular salary.

Stock grants, on the other hand, are often preferred for retaining employees. With a stock grant, you might not be vested until you’ve worked with the company for two years, five years, or more. If your stock grant has a two-year vesting period, you’re less likely to consider leaving to take a job somewhere else until after you’re fully vested.

Employee stock options and grants are complex securities with significant tax consequences, please consult an investing or accounting professional.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

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