Employee Stock Options: A Comprehensive Guide

Last updated 04/23/2024 by

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Summary:

Employee Stock Options (ESOs) are a popular form of equity compensation that companies offer to their employees and executives. ESOs are essentially call options that allow employees to buy the company’s stock at a specific price for a limited time. While ESOs can align employee interests with those of the company, it’s important to understand the ins and outs of ESOs and how they can benefit you. Employers also benefit from implementing an equity compensation plan, such as using compensation plans to attract top-notch talent, enhancing employee job satisfaction, and retention. Incentive stock options (ISOs) and Non-qualified stock options (NSOs) are the two main types of ESOs.

What is an employee stock option (ESO)?

Have you ever heard of an Employee Stock Option (ESO)? It’s a type of compensation that companies offer to their employees and executives. But instead of handing over actual shares of stock, they offer derivative options on the stock instead. These options are like regular call options and give employees the ability to buy the company’s stock at a specific price for a limited time. The specifics of these options are laid out in an employee stock options agreement, which outlines all the terms and conditions. If you’re an employee, it’s important to understand the ins and outs of ESOs and how they can benefit you.

ESOs are granted by companies and offer a significant benefit when the stock price rises above the exercise price. Unlike exchange-traded options, ESOs cannot be sold. Once the stock price exceeds the exercise price, the option can be exercised, allowing the holder to purchase stock at a discount. The stock can then be sold immediately for a profit or held for a longer period.

Discover employee stock options (ESOs)

Equity compensation plans are used by companies to reward and retain employees, and Employee Stock Options (ESOs) are one option among many others. Other types of equity compensation plans include restricted stock units, performance-based equity, and stock appreciation rights. Employees should evaluate each plan based on its rules and benefits and determine which is best for their financial goals and situation.

Types of equity compensation plans:

Restricted stock grants are awarded to employees who meet certain criteria, such as reaching specific performance targets or working for the company for a defined period.
Stock appreciation rights (SARs) provide employees with the right to the increase in value of a specific number of shares, which can be paid in cash or company stock.
Phantom stock is a future cash bonus that is equivalent to the value of a certain number of shares, with no legal transfer of share ownership.
Employee stock purchase plans allow employees to purchase company shares at a discount.

Equity compensation plans incentivize employees and stakeholders to contribute to a company’s growth and success through equity incentives. Equity compensation plans offer several benefits to employees, including the chance to share in the company’s success through stock ownership. Owning a stake in the company can motivate employees to be productive and invested in its growth. It can also provide a clear indication of the value of their contributions to the company. In some cases, these plans may also offer tax savings when the shares are sold or disposed of.

Employers also benefit from implementing an equity compensation plan. Some benefits include:

Using compensation plans as a vital tool to attract top-notch talent in a global economy with intense competition.
By providing lucrative financial incentives, companies can enhance employee job satisfaction and financial well-being.
With equity ownership, employees are more motivated to contribute towards the company’s success, which, in turn, results in their financial gain.
In some cases, equity compensation plans can be employed as a potential exit strategy for company owners.

ESOs come in two main types:

Incentive stock options (ISOs), which are usually offered to top management and key employees, receive preferential tax treatment from the IRS as long-term capital gains.
Non-qualified stock options (NSOs) can be granted to all levels of employees, board members, and consultants, and the profits on these are taxed as ordinary income.

Stock options are a popular incentive among startup companies, which may grant them to early employees in anticipation of the company going public. Growing companies may also use stock options as a means of rewarding employees for their efforts in increasing the company’s share value. By tying employee compensation to company performance, stock options can encourage employee loyalty and retention. However, if the employee leaves the company before the options are vested, they will be canceled. It is important to note that ESOs do not provide dividend or voting rights to employees.

The keys to ESOs

In the world of equity compensation, there are two major players involved in an employee stock option (ESO) agreement: the grantee (employee) and grantor (employer). The grantee, who may be an executive or any other employee, receives equity compensation in the form of ESOs from the grantor, which is the employing company. ESOs often have a vesting period that determines how long an employee must wait before exercising them. This period incentivizes employees to perform well and stay with the company, and the schedule is predetermined at the time of the option grant.

Vesting

While ESOs can align employee interests with those of the company, some companies may choose not to fully vest the stock when options are exercised to prevent employees from selling shares and leaving the company. Instead, stock may vest over time or other restrictions may be in place to ensure commitment to the company’s success. Understanding the rules and restrictions surrounding ESOs is important for both employees and employers.

To make the most of your ESOs, review the stock options plan and options agreement carefully. The plan outlines your rights, while the agreement includes details like the vesting schedule and strike price. Understanding these documents will help you make informed decisions about exercising your ESOs.

As a key employee or executive, you may have some room for negotiation when it comes to your options agreement. For example, you could potentially negotiate for a quicker vesting schedule or a lower exercise price. It’s important to consult with a financial planner or wealth manager before signing the agreement to ensure you fully understand its implications.

ESOs usually vest in predetermined chunks over time based on a vesting schedule. For example, a 1,000 share grant could have a vesting schedule of 25% annually over four years with a 10-year term. This means that 250 shares would vest after one year, another 25% after two years, and so on.

Let’s break down the timeline for exercising ESOs. After year one, 25% of your ESOs will be vested, meaning you can exercise the option to buy 250 shares. If you don’t exercise those options, you’ll still have the right to buy 250 shares plus an additional 25% (or 500 shares total) after year two. If you don’t exercise any options during the first four years, you’ll have 100% of your ESOs vested at that point, and you can choose to exercise them in part or in full. It’s important to note that ESOs typically have a term of 10 years, so if you don’t exercise them before that period is up, you lose the right to buy shares. This means you should be proactive about exercising your ESOs before the 10-year mark. If you have any questions about your options or how to exercise them, consider speaking with a financial planner or wealth manager.

Receiving stock

Let’s continue with the same example we’ve been discussing. Suppose you decide to exercise 25% of your ESOs when they become vested after one year. This would entitle you to purchase 250 shares of your company’s stock at the strike price specified in your options agreement. It’s important to note that the strike price is fixed and does not change, regardless of the current market price of the stock.

Reload option

Some ESO agreements may include a reload option, which can be a beneficial provision. This option allows an employee to receive additional ESOs when they exercise their current options.

ESOs and taxation

The ESO spread is the difference between the exercise price of the ESOs and the market price of the stock, and it will have tax implications for the holder of the ESOs.

The tax implications of ESOs:

Firstly, the grant of the option is not a taxable event, so the grantee won’t face immediate tax liabilities.
When the option is exercised, the difference between the exercise price and market price, called the spread or bargain element, is taxed at ordinary income tax rates as it’s considered part of the employee’s compensation.
If the acquired stock is sold within a year, it’s treated as a short-term capital gain and taxed at ordinary income tax rates.
But, if it’s sold more than a year after exercise, it qualifies for the lower capital gains tax rate.

Let’s consider an example to illustrate this. Suppose you hold ESOs allowing you to buy 1,000 shares of your company’s stock at a strike price of $25 per share. Let’s assume that the current market price of the stock is $55 per share, and you wish to exercise 25% of your options. In this case, you would need to pay $6,250 ($25 x 250 shares) to purchase the shares. If you immediately sell the acquired shares, you would receive $13,750, resulting in pre-tax earnings of $7,500. However, this spread between the strike price and the market price is taxable as ordinary income in the year of exercise, regardless of whether you sell the shares or not. This can lead to a significant tax liability if you hold onto the stock and its value drops after you exercise the options.

ESOs are taxed when exercised because the IRS considers the discounted price of the shares as part of an employee’s compensation. Even if the shares are not sold immediately, a tax liability is triggered at the time of exercise.

Comparing intrinsic value vs. time value for ESOs

ESOs are made up of two crucial elements: intrinsic value and time value. Intrinsic value is simple enough, based on the difference between the current stock price and the ESO exercise price.

It’s the complex interplay of time value that can make or break the value of your ESOs. With an expiration date that could be up to a decade away, ESOs can hold significant time value.

However, unlike exchange-traded options with transparent market prices, gauging the time value of non-traded ESOs can be as tricky as walking a tightrope.

To determine the time value of your ESOs, you’ll need to use a theoretical pricing model such as the Black-Scholes option pricing model. This model takes into account various inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility to estimate the fair value of your ESOs. From there, it’s a simple calculation to determine the time value of your ESOs.

Remember that intrinsic value is always positive and only exists when the option is “in the money.” This means that if your option is “at the money” or “out of the money,” the entire value of your ESOs will be made up of time value. By understanding these components, you can make more informed decisions about when and how to exercise your ESOs.

By exercising your ESOs, you capture the intrinsic value but forfeit the time value, which could lead to a hidden opportunity cost. For example, if your ESOs have a fair value of $40, including $30 intrinsic value and $10 time value, and you exercise 250 shares, you’d be sacrificing $10 per share, or a total of $2,500, in time value. This is why it’s crucial to consider both intrinsic and time value before exercising your ESOs to avoid losing out on potential gains.

The value of your ESOs is not constant and will vary over time depending on changes in critical factors such as the underlying stock’s price, the remaining time until expiration, and most importantly, volatility. Imagine a scenario where your ESOs are currently out of the money, which means that the stock’s current market price is lower than the exercise price of your ESOs.

Exercising ESOs may not be advisable in this scenario for two reasons: firstly, the stock can be purchased cheaper in the open market; secondly, there’s a significant time value component that would be forfeited if the ESOs are exercised. It may be better to hold onto the ESOs and purchase the stock at the exercise price of $25 for a potentially greater return. However, this comes with the risk of owning the shares.

Comparing ESOs to listed options

The primary distinction between ESOs and listed options is apparent: ESOs are not traded on an exchange, which means they lack the numerous advantages of exchange-traded options.

Why the value of your ESO is hard to pin down

Exchange-traded options have the benefit of being highly liquid, trading frequently, and providing a clear reference point for estimating the value of an options portfolio. ESOs, on the other hand, lack a market price reference point and can have terms of up to 10 years, making it challenging to ascertain their value. Even the longest-dated options available, LEAPs, only go three years out, which doesn’t help if your ESOs have a longer expiration date. To determine the value of your ESOs, it’s essential to use option pricing models. Your employer is obligated to specify a theoretical price of your ESOs on the grant date, so be sure to request this information and understand how the value was determined.

ESO prices can be highly variable due to assumptions made by the employer regarding variables such as length of employment and expected holding periods. Factors such as volatility can also significantly impact option prices. Comparing estimates from multiple models can help determine the fair value of your ESOs.

Standardization of specifics

The terms of listed options contracts are uniform, which means that the number of shares underlying the contract and the expiration date are standardized. This consistency makes it simple to trade options on any stock that can be optioned, whether it’s a big name like Apple, Google, or Qualcomm. If you trade a call option, for example, you have the option to buy 100 shares of the underlying stock at the strike price specified until the option expires.

ESOs provide the right to purchase company shares, but the terms can vary depending on the options agreement. This is different from listed options, which have standard terms for buying and selling underlying shares. For example, a put option allows the sale of 100 shares at a predetermined price, while a call option allows the purchase of 100 shares at a set price.

Lack of automatic exercise

In the U.S., all listed options have a standard last day of trading, which is the third Friday of the month in which the option contract was made. If the third Friday coincides with a stock exchange holiday, the expiration date is moved to the previous Thursday. When the options associated with a particular month’s contract stop trading at the end of the third Friday, they are automatically exercised if they are in the money by $0.01 or more.

For instance, if you have a call option contract and the market price of the underlying stock at expiration is above the strike price by a penny or more, you automatically acquire 100 shares through the exercise feature.

Similarly, if you have a put option and the market price is lower than the strike price by a penny or more, you are automatically short 100 shares. You have the option to override the automatic exercise feature by giving instructions to your broker or closing the position before expiration.

However, ESOs have different expiration details that vary between companies. There is no automatic exercise feature for ESOs, so you have to inform your employer if you want to exercise your options.

Strike prices

Standardized strike prices for listed options are set in specific increments, such as $1, $2.50, $5, or $10, depending on the underlying security’s price, with wider increments for higher-priced stocks. However, ESOs usually have strike prices set as the closing price of the stock on a particular day, resulting in no standardized strike prices.
During the mid-2000s, several high-ranking executives at various firms in the U.S. stepped down following an ESO backdating scandal. This unethical practice involved granting options at a previous date with a lower strike price than the market price on the grant date, resulting in instant gains for the option holder. The introduction of Sarbanes-Oxley has made backdating ESOs much more challenging by requiring companies to report option grants to the SEC within two business days.

Acquired stock restrictions and the vesting process

ESOs present control issues that do not exist with listed options due to the vesting process. Employees may have to meet certain performance targets or achieve a level of seniority before their options become vested. If the vesting requirements are not well-defined, it could create a murky legal situation, particularly if the relationship between the employee and employer sours. In contrast, listed options do not impose restrictions once the option is exercised and the underlying stock is obtained.

ESOs may come with restrictions that limit your ability to sell the stock obtained through the exercise of options. Additionally, if the acquired stock is unvested, you may face a challenging situation where you have already paid taxes on the ESO spread, but cannot sell the stock or it is decreasing in value.

ESOs and counterparty risk

ESOs come with counterparty risk since the employer is the counterparty without an intermediary, unlike listed options in the U.S where the Options Clearing Corporation acts as a clearinghouse. It is crucial to keep track of the employer’s financial health to avoid unexercised options or worthless acquired stock. Employees who received ESOs during the dot-com bust of the 1990s learned about this risk the hard way.

Concentration risk

Diversification is possible with listed options, but not with ESOs due to concentration risk. Owning a significant amount of company stock through an ESOP can also result in overexposure to the company, which is a concentration risk. This risk has been highlighted by FINRA.

Valuation of ESOs and pricing issues

To truly understand the value of your employee stock options (ESOs), you need to be aware of the factors that influence them. Volatility, time to expiration, risk-free rate of interest, strike price, and underlying stock price all play a role. Knowing how these variables interact, particularly volatility and time to expiration, is essential to making informed decisions about your ESOs. Consider the example of an ESO that allows you to purchase 1,000 shares of your company at a strike price of $50 upon vesting, which was the stock’s closing price on the option grant date. This means that the option was granted at-the-money, but the true value of the ESO will depend on many other factors.

As the expiration date of an option approaches, its value decreases. Conversely, the longer the time to expiration, the greater the option’s worth. In the case of an at-the-money option, its value is comprised solely of time value.

The amount of time until expiration plays a crucial role in options pricing, with time value being a significant component. Suppose you receive at-the-money ESOs with a 10-year term. Although they have no intrinsic value, each option holds a significant amount of time value, valued at $23.08 per option or over $23,000 for 1,000 shares.

Option time decay is not linear and speeds up as the expiration date approaches. This phenomenon is known as time decay, which affects out-of-the-money options more than at-the-money options since the former has a much lower probability of becoming profitable.

The volatility of a stock plays a crucial role in determining the price of an ESO. If we assume a volatility of 30%, an ESO with 10 years remaining until expiration would be priced at $23.08 per option. However, if we increase the volatility to 60%, the price of the ESO increases significantly to $35.34, which is a 53% increase. Similarly, with only two years remaining until expiration, an increase in volatility from 30% to 60% would cause the price of the ESO to increase by 80% to $17.45.

If we look at the current prevailing levels of volatility and risk-free interest rate, we can get an idea of how ESOs would be priced. For instance, with a 10% volatility and a 2% risk-free interest rate, an ESO with 10 years remaining would be priced at $11.36 per option, while one with only two years remaining would be priced at $3.86 per option.

It’s crucial to keep in mind that ESOs can still hold significant time value, even if they currently have no intrinsic value. Their longer expiration period compared to listed options means that early exercise can result in wasting this valuable time value. Therefore, it’s essential to carefully consider the potential future value of your ESOs before deciding to exercise them early.

Measuring risk and reward with owning ESOs

ESOs can have significant value even if they appear to have no intrinsic worth. ESOs have a longer expiration period compared to listed options, which means they can possess a substantial amount of time value that shouldn’t be wasted through early exercise.

Additionally, ESOs can provide the opportunity to benefit from stock price appreciation over a longer period of time, which can result in a greater potential return. However, holding onto ESOs also comes with risk, as the value of the options can decrease if the stock price does not perform as expected. In this section, we’ll illustrate how owning ESOs can involve risk and reward using the standard 10-year grant term to expiration.

ESOs may seem worthless at the grant date with a strike price equal to the stock’s closing price. However, the high time value component means that early exercise can lead to a significant opportunity cost. Understanding this component is crucial to avoid this risk.

Suppose you’re holding 1,000 ESOs with a $50 strike price, 10-year expiration, and 60% volatility. This scenario could result in losing significant time value. If the underlying stock remains stagnant at $50 after 10 years, the loss of time value could be as high as $35,000, leaving you with nothing to show for your ESOs.

Let’s say the stock rises to $110 by expiration, resulting in an ESO spread of $60 per share or $60,000 in total. However, you need to account for the $35,000 loss in time value by holding the ESOs to expiration. This means that your pre-tax gain would only be $25,000, subject to an ordinary income tax rate of 40%. After compensating your employer with $24,000 in taxes at exercise, you would be left with $36,000 in after-tax income, but after factoring in the $35,000 lost in time value, you would only have $1,000 in hand. It’s crucial to keep these factors in mind when deciding whether to exercise your ESOs.

Holding onto ESOs until expiration date

Let’s take a closer look at the outcomes of holding your ESOs until expiration and the costs involved. Assuming a stock price of $120 upon expiration, your actual gains after factoring in time value and tax costs are just $7,000. Although the spread of $70 per share or $70,000 in total may seem lucrative, you must subtract the compensation tax of $28,000 and the $35,000 loss in time value, leaving you with a net gain of $7,000.

Exercising ESOs triggers a tax event, requiring payment of the exercise price plus tax, even if you don’t sell the stock. In the given scenario, exercising ESOs for 1,000 shares at $50 per share with taxes ($28,000) would cost $78,000. Selling the stock immediately at $120 per share would yield $120,000. But after accounting for the $78,000 cost, you would only gain $42,000. However, this gain is offset by the $35,000 loss in time value, resulting in only $7,000 in net gains.

ESOs and premature exercise

If you’ve got employee stock options (ESOs), you may be tempted to exercise them early to secure your gains and minimize your risks. But beware that this move could come with a hefty tax bill and cause you to miss out on potential future gains. That’s why it’s crucial to weigh the pros and cons before making any decisions.

When an ESO is granted, it has a hypothetical value that’s entirely based on time, because it is an at-the-money option. As the clock ticks down, that time value starts to decay at a rate known as theta, which is a square root function of the time remaining.

Let’s say you have ESOs worth $35,000 at the time they were granted, and you’re in it for the long haul, planning to hold onto them until they expire.

Even if you begin to gain intrinsic value as the price of the underlying stock rises, you will be shedding time value along the way (although not proportionately). For example, for an in-the-money ESO with a $50 exercise price and a stock price of $75, there will be less time value and more intrinsic value, for more value overall.

As options move further out-of-the-money, their time value decreases because the chances of them becoming profitable are slim. On the other hand, as options become more in-the-money, their intrinsic value increases and becomes a larger proportion of their total value. In some cases, the time value becomes insignificant compared to the intrinsic value. When the intrinsic value is at risk, some option holders may choose to lock in their gains, but doing so means giving up time value and potentially incurring high taxes.

Tax liabilities and ESOs

If you exercise your employee stock options (ESOs) early, you’re in for a big tax hit and could lose out on valuable time value. You’ll be taxed at ordinary income tax rates on the ESO spread or intrinsic value gain, which can be as high as 40%. And that tax bill will be due in the same year you exercise your options, with the possibility of another tax hit when you sell the stock later on.

Even if you have capital losses in other parts of your portfolio, you can only use up to $3,000 per year of those losses to offset the tax liability from your ESO gains.
After you have acquired stock that presumably has appreciated in value, you are faced with the choice of liquidating the stock or holding it. If you sell immediately upon exercise, you will have locked in your compensation “gains” (the difference between the exercise price and stock market price).

If you hold onto the stock acquired through exercising your ESOs and then sell it later for a profit, you may be subject to additional taxes. The stock price on the day you exercised your options becomes your “basis price,” and if you sell the stock within a year of exercise, you’ll pay short-term capital gains tax. To get the lower long-term capital gains rate, you’ll need to hold the shares for more than a year. So by exercising your ESOs early, you may end up paying both compensation and capital gains taxes.

Many ESO holders may also find themselves in the unfortunate position of holding on to shares that reverse their initial gains after exercise.

Let’s say you’re holding onto employee stock options (ESOs) that give you the right to buy 1,000 shares at $50 each. The stock is currently trading at $75 with five years until the options expire, but you’re feeling nervous about the market or the company’s future.
You then decide to sell 500 of those shares and hold onto the other 500 in hopes of further price appreciation. So what are the financial implications of this decision? Let’s crunch some numbers:

After exercising your ESOs at $75 and paying compensation tax on the spread of $25 x 1,000 shares at a rate of 40%, you are left with $2,500 in after-tax gains from selling 500 shares at $75. You still hold 500 shares with a basis price of $75 and unrealized gains of $12,500.
Let’s say the stock declines to $50 before year-end, your holdings would then lose $12,500 or $25 per share.

If you sell these shares at $50, you can only apply $3,000 of these losses in the same tax year, with the rest to be applied in future years.

In summary:

After exercising and paying $10,000 in compensation tax, you gained $2,500 on 500 shares and broke even on the other 500. However, with a decline in stock price, you now have $12,500 in losses that can be written off $3,000 per year.

By exercising ESOs early, there is a loss of time value which could be substantial if there is still significant time left before the expiration date. Moreover, you would no longer be able to benefit from a potential rise in the stock price after exercising your ESOs. It is generally not advisable to exercise listed options early, but certain situations may require early exercise of ESOs due to their non-tradable nature and other restrictions:

Need for immediate cash flow.
Diversification of portfolio due to an overly concentrated position in the company’s stock.
Locking in gains due to a deteriorating outlook for the stock or equity market in general.
Delivery of stock for a hedging strategy involving writing calls.

Basics of hedging strategies for ESOs

There are several basic hedging strategies for ESOs, including writing calls, buying puts, and constructing costless collars. Writing calls is the only strategy that can counteract the erosion of time value in ESOs by taking advantage of time decay. It’s important to consult with a financial planner or wealth manager before employing any of these strategies. Additionally, check your company’s code of ethics and policies as there may be restrictions on dealing in options related to your company if you’re considered an insider.

To illustrate hedging, let’s consider options on XYZ Corp. Assume that on November 15, the longest-dated options available are three-year calls and puts, and the stock closed at $175.13.

As an XYZ employee, you have been granted ESOs to buy 500 shares of the company that will vest in 1/3 increments over the next three years and have 10 years to expiration. The market price for the three-year $175 calls is $32.81 and the 175 puts trade at $24.05.

Here are three basic hedging strategies to consider for a 500-share long position, assuming a three-year hedging period.

Write Calls: If you’re neutral to moderately bullish on XYZ, you can hedge your potential 500-share long position by writing covered calls. Write five contracts with a strike price of $250 and receive a total of $5,275 in premium. If the stock stays flat or decreases, you keep the premium and can repeat the strategy. If the stock rises, you would still receive $250 per share and the premium, resulting in a return of nearly 50%. You could also write one call contract for each of the next three years.

Buy Puts: Buying puts is a strategy for downside protection when you are bearish on XYZ’s prospects. You can buy five contracts of the three-year $150 puts for $14.20 each, which costs $7,100 in total. You would break even if the stock trades at $135.80 and make money if it falls below that level. If the stock doesn’t drop below $150 within three years, you would lose the full $7,100, but if it trades between $135.80 and $150, you would recoup part of the premium. This strategy can be pursued as a stand-alone strategy and does not require exercising ESOs.

Costless Collar: The Costless Collar strategy allows you to create a trading range for your XYZ holdings with minimal upfront cost. You can use the premium received from selling 3-year $215 calls (at $19.90 per share) to purchase 3-year $165 puts (at $19.52 per share). With this strategy, your stock may be called away if it trades above $215, but your downside risk is limited to $165.

Writing calls is the only strategy that can counteract the effect of time decay on ESOs. Buying puts is useful to mitigate downside risk, but it worsens the issue of time decay. On the other hand, costless collar has minimal cost but cannot resolve the problem of ESO time decay.

The difference between ESOs and listed options

ESOs have distinct differences from exchange-traded options, such as their value not being easily determined, lack of standardized specifications and automatic exercise. Holders should be aware of counterparty and concentration risks.

What is the worth of ESOs at First?

ESOs may not have intrinsic value at the time of option grant, but they possess significant time value due to their longer expiration period compared to listed options. Therefore, it is not wise to forfeit this time value through early exercise.

What are the tax liabilities related to ESOs?

ESOs become taxable at exercise and selling the acquired stock incurs another taxable event. This tax liability is a significant deterrent for early exercise. However, in certain cases, early exercise may be justified such as when cash is needed, diversification is required, the stock outlook is deteriorating, or when stock is needed for hedging through calls.

Final Thoughts

Imagine you work at a company and your boss tells you they want to give you a piece of the pie. That pie is a slice of the company’s stock, and the way they’ll give it to you is through something called an Employee Stock Option (ESO). It’s kind of like a regular call option, where you have the right to buy the company’s stock at a specific price for a set amount of time. ESOs are a popular way for companies to reward their employees and top executives, but there are other types of equity compensation too.

Stock options come in two types: incentive stock options (ISOs) and non-qualified stock options (NSOs). ISOs are typically reserved for top management and receive favorable tax treatment from the IRS. NSOs, on the other hand, can be granted to any employee or consultant and are taxed as ordinary income.

To maximize the benefits of ESOs, holders should review their company’s stock options plan and agreement for restrictions and clauses, and be aware of their company’s code of ethics. Consulting with a financial planner or wealth manager can also help employees navigate the complexities of equity compensation.

Key takeaways

ESOs are offered by companies as part of their equity compensation plans to reward and motivate their employees.
ESOs are essentially call options that allow an employee to purchase the company’s stock at a specific price for a set period.
There may be limitations on when an employee can exercise their ESOs, as determined by a vesting schedule.
ESOs are subject to taxation at the time of exercise, and employees who later sell their shares will also face taxes.
Even if the current stock price is lower than the exercise price of an ESO, it may still hold value due to its time value. In other words, it may be worth exercising an ESO even if it’s not “in the money” yet.

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