Employee Stock Options: A Complete Guide to Understanding Your Benefits

Employee stock options are a popular form of equity compensation that is often offered by companies as a way to attract and retain top talent. It allows employees to purchase company stock at a discounted price, known as the grant price, and to sell it at a later date for a profit. In this guide, we will provide an overview of employee stock options equity compensation, including how it works, the tax implications, and the risks and rewards associated with this type of investment. We will also discuss the different types of options plans, such as incentive stock options (ISOs) and non-qualified stock options (NSOs), and how they differ. If you are an employee considering participating in a stock options equity compensation plan, this guide will provide you with the information you need to make informed decisions.

What are Employee Stock Options?

Employee stock options give you the right to buy a specific number of shares of company stock at a pre-set price following a vesting period. If your pre-set price is $10 and the stock is currently at $50 you pay $10/ share. This is known as the exercise or strike price. When you hit the first vesting period you can exercise your stock options. After you hit that vesting period, you have the right to purchase company stock at that predetermined price whenever you want. It can be that same day, it can be 2 years later – the choice is yours.

To motivate employees to work hard and drive the stock price up a company might grant a large number of options that are significantly below the current market price. Combined with your flexibility to sell any time after they vest, you may have the ability to purchase shares significantly below the current market value. Conversely, if the stock price does not go up significantly, you may not be able to benefit from the equity compensation at up. The stock price could even decline to the point where your equity compensation ends up worthless.

Different Types of Employee Stock Options: NSOs and ISOs

There are two types of employee stock options: Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). ISOs and NSOs employee stock options have distinct tax implications.

ISOs are eligible for special tax treatment. When an ISO is exercised, the employee does not have to pay ordinary income tax on the difference between the grant price and the fair market value of the stock at the time of exercise. Instead, the employee may be eligible for long-term capital gains tax treatment if they hold the stock for at least one year from the date of exercise and two years from the date of grant.
NSOs are not eligible for special tax treatment. When an NSO is exercised, the employee has to pay ordinary income tax on the difference between the grant price and the fair market value of the stock at the time of exercise. The employer may also be subject to payroll taxes on the income recognized by the employee.
ISOs are also subject to more stringent rules regarding eligibility, exercise price and holding periods. For example, ISOs are only available to employees, and the exercise price must be at least equal to the fair market value of the stock at the time of grant.
NSOs are more flexible, they are available to employees, as well as non-employee directors and consultants. They also have fewer restrictions on the exercise price and holding periods, which means they may be less expensive for the company to grant.

In summary, ISOs offer certain tax advantages but are subject to more restrictive rules. NSOs do not have the same tax benefits but are more flexible in terms of eligibility and exercise price.

Exercising Employee Stock Options

When your options vest, nothing happens unless you decide to exercise your option to buy. If you exercise your option to buy, you can initiate an exercise-and-hold transaction (cash for stock), initiate an exercise-and-sell-to-cover transaction or initiate an exercise-and-sell transaction (cashless) depending on your personal situation and goals.

Employee Stock Options Selling

With employee stock options, nothing happens until you decide to exercise your options. You can decide to sell your options that day, or years later. However, your vested options are still tied to your employment with the company. If you decide to leave the company you will likely need to exercise your vested options within 90 days.

Employee Stock Options Tax Treatment

With employee stock options, how you are taxed depends on what type of stock options you have. There are two main types of employee stock options – non-qualified stock options (NSOs) and incentive stock options (ISOs). If you have NSOs, you are taxed as ordinary income when you initially exercise the stock for the difference between the current stock price and the price you bought it at. With ISOs, you get taxed when you sell the shares. If you sell the shares after holding less than a year you’ll be subject to short term gains taxes. If you sell the shares after holding longer than a year you’ll be subject to long term capital gains taxes.

Employee Stock Options Summary

In summary, employee stock options can be an attractive form of compensation, as they provide the potential for financial gain through ownership in the company. However, it is important to have a clear understanding of the terms and conditions of the stock options, including vesting periods, exercise prices and taxes.