Employee Stock Option (ESO)

What is an Employee Stock Option (ESO)?

Employee Stock Option refers to the practice of providing employees with stock in the company. They are usually issued at a lower price than the current price at which the stock is listed on the exchange.

Consider a stock currently trading on the stock exchange; it might be from any company. On the stock exchange, these stocks are traded at a price. Therefore, you can purchase these stocks at their current market price.

Employee stock options are not the same as stocks. The corporation does not give you stock but rather the option to purchase these stocks at a later date. This is a fantastic option because if the business performs well, you will accumulate wealth over time.

There are four things you should consider before exercising an ESO:

1. Value of Employee Stock Option: How many ESOs are you getting, and what is their value?
2. Vesting Period: In how much time will you get these ESOs?
3. Cliff: What is the period you must be in the company to become eligible for ESO?
4. Exercise Period: Which is after leaving the company, how much time will you get to exercise these options?

Types of ESO

There are two types of employee stock options that a company can offer to its employees:

1. Non-Qualified Stock Options 

These are the most common types of ESO. In this option, the employee does not receive any particular tax treatment. They have to pay tax on the difference between the stock's market value and the value at which they have been granted the stock.

2. Incentive Stock Options

These are particular types of ESO. In this, the beneficiary receives special tax treatment. For example, it may so happen that they have to pay capital gains tax, thereby keeping more money as compared to Non-Qualified Stock Options (NSO).

Aside from these two, there are a few more kinds of ESOs:

1. RSUs (Restricted Stock Units): Employees receive a defined quantity of firm stocks at a predetermined moment in the future under these arrangements.
2. PSOs (Performance Stock Options): These options are only awarded to employees if the company meets specific performance parameters.
3. Employee Stock Purchase Plans (ESPPs): These plans permit you to purchase company stock at a discounted price. The amount is knocked off your income regularly.

ESPP Vs. ESOP

An ESPP employee stock purchase plan allows employees to purchase stock with after-tax money. Why they are sometimes attractive is that the purchase price is below market. In addition, the company wants to encourage ownership of its stock by its employees.

The merit of an ESPP is that the purchase price is often below the market price, so the employees can profit if the stock increases in value. This is a benefit the employees can receive in addition to their salary.

After a minimum holding time, that stock can be bought or sold. And ESOP, an employee stock ownership plan, on the other hand, functions more like a 401k. The company creates employee accounts and puts company stock in those accounts.

Nothing can be done with that stake until retirement from the firm. At retirement, typically, the firm purchases the stock back from the employee at the then-current market rate.

This is all pre-tax money. So an ESPP is an agreement to get a percentage of your income in company stock, while an ESOP is a form of retirement account the firm offers for employees. An ESOP is a form of retirement account the firm offers for employees.

How does the Employee Stock Option work?

Let us suppose XYZ company’s share today is $32 per share, and the company is giving you the option to buy it anytime in the next five years for $32.

So, the way in which it becomes valuable is if, in five years, the share price is $50 per share, then each option is worth $50 - $32 = $18, which is essentially the delta. The cap on the maximum amount of delta.

That is why early employees of super-successful companies are wealthy because they have stock options in the company.

Now if in five years, the share price of XYZ company is less than $32, then the options are worth $0 because there is no reason why you would purchase a $32 stock when it is available in the markets at a lesser price.

But since you can buy them, there is no risk involved on your part.

Risk and Reward Associated With Owning ESOs

The government says that when converting these options into stocks, you are generating income for yourself, which means you have to pay income tax on this income. But the problem is you have not received any tangible income against these stocks.

You have become just the owner of these stocks, but you still have to pay the money to the government in the form of tax.

That is why most people don’t exercise their options. Instead, they wait for the right time to convert these stocks to cash which can be a new funding round, an IPO, a sale, secondary purchase.

So, the bottom line is if you have to convert stocks to money, there is an event, and on that event’ only people exercise their options because they say if even we have to pay taxes, they won't have any problem. After all, they are getting some tangible money.

The exercise period is a very important and unknown part of the options, which will be explained below.

ESOs Important Concepts

The first term we come across whenever the topic of Employee Stock Options is touched is the vesting period.

1. Vesting period 

It means at what time or by what time will you be getting the ESO?

A company would never want that when you join, they give you two Employee Stock Options, and you leave the company after a month and take these two ESO with you. It does not work that way. The company doesn’t benefit at all, right?

So, what they will do is, put these employee stock options in a vesting period. Reiterating again, the vesting period is the time within which you will get these employee stock options.

a. What does it do for the company?

It ensures that if these Employee Stock Options are essential for an employee, then that employee will remain in that company to get Employee Stock Options. It also helps them to spread these ESOs over a period of time.

b. What does it do for the employee?

With each year passing, employees get some ESOs that can give them a sense of achievement and fulfillment.

c. How does it happen?

Typically, there is equal vesting which means that every year you will be getting an equal number of stocks or any other derivative given to you by the company. 

2. CLIFF

Companies don’t want you to take two years of vesting and leave. They want you to spend some minimum time in the company. It means how much you will have to climb to earn ESOs hence the word cliff.

3. Exercise Period

Employee Stock Option, focus on the word option. This means you can buy a company’s stock, which does not necessarily mean that you have the company’s stock. This is where the exercise period comes in.

You will get a time called the exercise period to exercise this option.

There are a lot of companies that give just three months after you leave the company to convert your ESOs into stocks. Still, in hindsight, these companies have realized that this approach is unfair towards the employees because if you don’t convert these, your ESOs will vanish.

We have a lot of companies that are thankfully employee-friendly, and they give around five to ten years to the employees to exercise their options.

Researched and Authored by Garv Mittal | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Employee Stock Ownership Plan (ESOP)
• Exempt Employee
• Financial Analyst Salary Guide
• Gross Pay
• Hedge Fund Salary Guide