Many of us have heard of employee stock options from family, friends, jobs and corporations. Employee stock options (ESOS) are benefits given to employees for incentive to keep productivity high. Companies well known for offering employee stock options are Amazon, Intuit, Whole Foods and Aflac.
How Do Employee Stock Options Work (ESOs)?
Employee stock options are defined by contracts that entitles the employee(s) to purchase and hold a company shares for specified amounts of time. Essentially, the ESOS shares similarities to exchanged-traded and call options in that they must be traded to receive shares.
So, what does this all mean? To put it in simple terms, ESOS gives the employee(s) the right, but no obligation to exercise. If the stock then moves and appreciates then the employee has the right to exercise and take profit. While, if the stock moves and depreciates in price, the employee doesn’t have to exercise.
To understand a bit more let’s say John is working at ABC company and gets an option for 100 shares for $5 each. ABC company’s stock goes up to $10. John can now decide if he wants to exercise his option to buy 100 shares and sell them for $10 a share. This means he would be profiting $500 in the difference ($1000-$500=$500). If John decides not to exercise the shares expires and John isn’t at a loss.
What Is the Strike Price or Grant Price?
The strike or grant price are interchangeable phrases in reference to exercising options. It is price the employee must pay when purchasing shares.
The strike price is a fixed price that stocks can be purchased at. Typically the strike price is lower than the current market value for the stock. This gives employees the chance to purchase stock at discounted prices that have potential to increase rapidly or steadily over time.
What Is the Issue Date?
An issue date is the date at which the option is given to you. You may see this typically written out on a contract explaining when you will have access to the shares.
What Is the Vesting Date?
The vesting date is the date you are able to exercise the options. This is dictated by the company, which will not allow for you to exercise before or after the expiration date. In turn, you need to work and stay employed by the company issuing ESOS for a certain amount of time before you’ll have the ability to exercise.
While many employers will give predetermined dates when employees must exercise, there are times when employers can exercise after the vesting period. Within any ESOS there is a vesting schedule, this outlines when you will have the ability to purchase the shares. Companies tend to use vesting schedules as incentive for employees to stay with the company longer.
What Is the Exercise Date?
When one exercises a stock option, then the shares are bought under agreement on specified prices. Typically the price will be far less than market value of the stock.
What Is the Expiration Date?
The expiration date is the last day one can exercise options. Once the expiration date has passed the options typically will lose all value. With ESOS, if the employee were to leave the company before the expiration date, the shares will expire sooner and there will be less time to exercise.
Ways to Exercise Employee Stock Options
ESOS gives employees the right to purchase a specified number of shares within a specified time in their company. ESOS are a way for companies to give back to employees by letting them be a part of company growth.
This method allows for employees to be a part of the company’s stock without taking on the financial risks. So, let’s stop over some of the ways you can exercise ESOS.
Cash is an easy way to pay the upfront cost to exercise options. Those willing to use cash typically benefit by the chance of getting the highest number of shares owned.
This is due to the fact that you would need to use your own money to buy the shares, but this means you have 100% ownership. While there is a lot of risk due to the fact that 100% of your money if put into the shares, there is a chance to take profit.
A cashless exercise requires you to use shares to cover the exercise cost. This is known as a cashless sell to cover exercise. Another way to use a cashless exercise is by selling all options at one time. This in turn will allow you to profit from the amount left over after the fees and purchase price.
Stock swaps are a great tactic to pair with ESOs. They use fair market value when determining company stock purchased by the employee to use to pay for cost to exercise new ESOs shares. By using this tactic the employee is set to pay far less in taxes as long as the shares are held for a set period of time.
Types of ESOs
There are two types of employee stock options, incentive stock options and non-qualified stock options. Both have benefits for different groups/levels of employment. Because of this they are both taxed differently.
What Are Non-Qualified Stock Options?
Non-qualified stock options are the most common form of stock option. NQSOS are given to all employees throughout the company. Because the options are non-qualified, they are taxed as regular income and will not need any special tax according to the IRS.
What Are Incentive Stock Options?
Incentive options are offered typically only to upper level employees. Incentive stock options are given out to keep employees within the company long term. Companies will issue ISOS to really help the company grow in the long term by its incentive. ISOs are taxed far less than NQSOs since the holder cannot exercise for a longer period of time.
Benefits & Disadvantages of ESO’s
ESOS makes sense for a lot of businesses to give out. Depending on the employees receiving ESOS may be beneficial with long term goals within a company. But, there are many reasons ESOS may not benefit either the employee or employer. It’s important to weigh out the advantages and disadvantages before deciding if ESOS are best.
Benefits of ESOs
- Employees can take profit: Employees are able to benefit in the success of the business which allows them to take financial profit.
- Dedication: Employees who are invested into the business in turn will want to dedicate more time in the work to to increase growth.
- Low turnover rates: If the company is increasing in value over time, employees are less likely to quit since shares may not be accessed outside the vesting schedule.
- Cash flow: While some businesses may not have the cash flow to allow for pay increases or incentives such as paid lunches. ESOS could be a great benefit to give to employees.
Disadvantages of ESOs
- Taxes: While stock options can accumulate in profit, the IRS may have specified taxes on the profits which can vary in percentages and become complicated to calculate.
- Declining business: If the business is set to decline in value, employees will in turn lose value on the shares.
- Lost shares: Employees not looking to work for a company long term or have invents happen which causes them to quit or take leave can mean losing out on shares.
- Savings are at risk: Employees putting all their savings into ESOS are at a much higher risk of losing money. Because so much can vary within an organization, one wrong move could cost half of your savings. It’s important to diversify your portfolio because of this.
What Are the Tax Implications of Exercising Stock Options?
Since employees do not receive profits immediately after purchase, taxes should be put into consideration once profits received. That means employees will not have to show if the stock options have gains or losses until exercised.
NQSOS requires for the employee to report the gains and losses, these are then tax under ordinary income tax. While ISOS usually involves alternative minimum tax implications. These tend to involve higher tax implications than ordinary tax while offering less tax breaks. Employees will end up paying the tentative minimum tax with ISOS because of the secondary tax calculations used each year when filing.
Are Employee Stock Options a Good Fit For You?
ESOS are complicated to price and until employees reach a vesting period where they are able to exercise, the will be unable to act on the options. In this instance employees will only be able to estimate the profits to be received. With so much volatility, it’s important to understand the contract your ESOS are made on and if ESOS will really benefit you.
Those who are not looking to invest to much time within a company should steer clear of ESOS. By having investments into these options you must be tied down with the company for extended time. But those who are looking to benefit from options in lieu of public increases or company incentives. ESOS may be the best choice when working at a company long term
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