How Do Employee Stock Options Work? A Complete Guide to ESOs

Many employees have a benefit they may not be fully aware of, or they may not understand employee stock options. Employee stock options, also referred to as company stock options or ESOs, are a type of call option that gives employees the right to purchase company stock at a set price within a set time period.

Depending on the company, the strike price, and other factors, employee stock options can be a valuable benefit or essentially worthless. This guide covers what employee stock options are, why employers offer them, how they are taxed, and what you should do with them.

What Are Employee Stock Options?

A stock is an ownership stake in a company. A stock option is a contract that allows you to purchase shares of stock for a certain period of time at a certain price. If the owner has not exercised the option by the expiration date, it expires and becomes worthless.

When a company offers stock options to employees, it is offering them the opportunity to purchase ownership in the company, typically by allowing employees to buy a specified number of shares at a price established by the company within a set time period.

This can present a significant buying opportunity if the strike price is lower than the current market price. If the strike price is substantially higher than the market price, the options may be essentially worthless.

For example, an employee might hold a call option to purchase 100 shares of a company at $25 per share. If the stock price is above $25, the option has intrinsic value and is considered in the money. If the stock price equals $25, the option is at the money. If it is less than $25, the option is out of the money and has no intrinsic value.

Why Do Stock Options Exist?

Stock options exist primarily because they allow investors to use leverage to expand their potential returns without committing the full cost of purchasing stock outright.

Using the example above, an investor could either purchase stock directly, costing $2,500 for 100 shares at $25, or purchase a call option for considerably less. With the option, there are three possible outcomes:

• If the stock appreciates: You can exercise the option, own the stock, and potentially sell immediately for a profit

• If the stock appreciates: You can sell the option itself to another investor for a profit, without ever owning the underlying stock

• If the stock loses value: You can let the option expire; your maximum loss is limited to the premium paid for the option

This limited downside is the key advantage of options over direct stock ownership for speculative positions.

Why Do Employers Issue Employee Stock Options?

Employers offer ESOs as a way to compensate, attract, and retain talented employees who want to share in the company’s long-term success. Offering ESOs gives employees a direct financial stake in the company’s performance, aligning employee effort with company results.

ESOs are particularly common at startups and early-stage companies that want to attract talented employees while conserving cash. Rather than paying a higher salary, a company can offer ESOs that could become extremely valuable if the company grows.

There are a few important differences between ESOs and standard traded stock options:

• ESOs are typically not traded on any exchange; they are a private contract between employer and employee

• There are usually restrictions on when employees can exercise ESOs, known as the vesting period

• ESOs have different tax treatment than standard traded options since they are a form of employee compensation

Benefits of Employee Stock Options

Employee stock options can benefit both employers and employees:

For employees: ESOs offer the opportunity to purchase company stock at a potentially favorable price and to participate in the company’s growth without putting up significant capital upfront.

For employers: ESOs help attract and retain talent, align employee interests with company performance, and allow early-stage companies to offer competitive compensation packages while conserving cash.

Many employers offer ESOs at a fixed strike price based on the stock value on a predetermined calendar date, such as the closing price on the first day of the fiscal year. Some companies even offer employees the ability to purchase options at a discount to the stock price on a predetermined date.

Types of Employee Stock Options

There are two main types of ESOs: statutory and non-statutory:

Statutory Stock Options (ISOs)

Statutory stock options, also known as Incentive Stock Options (ISOs) or Qualified Stock Options (QSOs), qualify for preferential tax treatment for employees. However, this preferential treatment comes with specific holding period requirements. The IRS Publication 525 contains detailed information on what constitutes a statutory stock option.

Non-Statutory Stock Options (NSOs)

Non-statutory stock options, also known as Non-Qualified Stock Options (NSOs), are any stock options that do not qualify as statutory options. This can happen in two ways: either the company specifically grants the ESO as a non-qualified option, or the company grants an ISO that fails to meet the qualifying criteria for preferential tax treatment, known as a disqualifying disposition.

Three Key Dates That Affect Your Employee Stock Options

Three key dates impact the tax treatment and value of ESOs:

• Grant date — when the employer grants the options to the employee. At this point, the employee has only the right to buy stock, not the stock itself

• Exercise date — when the employee decides to exercise the option and purchase the stock

• Sale date — when the employee decides to sell the stock

How Employee Stock Option Vesting Periods Work

A vesting period defines when an employee is allowed to exercise their company stock options. Most companies spread vesting over several years, allowing employees to exercise only a portion of their options each year.

For example, an employee offered 100 shares with a four-year vesting schedule would be able to exercise 25 shares per year, becoming fully vested after four years. The vesting period varies by company, with some requiring several years of service before any options can be exercised.

What Can Employees Do with Company Stock Options?

Employees with vested stock options have several choices:

Convert and Sell — purchase the discounted shares, convert the options into stock, and sell all shares immediately after the required waiting period. This is the most common approach for employees who want to capture the value without concentrating their portfolio in a single stock.

Sell and Keep — purchase the discounted shares, sell some of the stock immediately after the waiting period, and hold the remainder to sell at a later date if the price rises.

Sell Later — purchase all options, convert them into stock, and hold the entire position with the intent to sell when the share price has increased.

Transferring Your Stock

If you leave a company, the vested portion of your stock options is yours to keep. If you have converted your options into stock and plan to hold them, consider transferring to a personal brokerage account. Several well-regarded brokerages for managing transferred stock include:

Ally Invest offers commission-free stock and ETF trades with no account minimum, one of the most cost-effective options for managing individual stock positions.

Charles Schwab, formerly TD Ameritrade, which merged with Schwab in 2020, offers a full range of investment services, research tools, and retirement account options suitable for managing transferred employer stock.

Morgan Stanley E*Trade is a full-service brokerage with robust tools for managing individual stock positions across taxable and retirement accounts.

Should You Exercise Employee Stock Options?

Company stock options come with inherent risk worth carefully considering before exercising:

• Most financial experts recommend against concentrating too much of your portfolio in a single company’s stock, even your own employer

• Options have an expiration date. Monitor the stock price leading up to expiration to understand the value of your options before they expire worthless

• If you receive ESOs at a favorable strike price and can make a profit, exercising and immediately selling to avoid over-concentration in a single stock is often the most prudent approach

• Always consider the tax implications before exercising. Consult a fee-only financial planner or tax professional to understand the full financial impact

Tax Treatment of Employee Stock Options

Tax treatment is the primary difference between NSOs and ISOs.

NSO Tax Treatment

For the employee:

• Upon grant, the employee may be subject to ordinary income tax depending on whether there are restrictions on exercise and whether the exercise price is below the market price at grant

• Upon exercise, the employee owes ordinary income tax, not capital gains tax, on the difference between the option price and the stock price at exercise. This difference is known as the bargain element. For example, options to purchase 1,000 shares at $25 per share exercised when the stock is at $40 would result in $15,000 of ordinary income

• The employer is required to withhold all applicable taxes on NSO exercise

• Upon sale, standard capital gains rules apply: short-term gains for stock held one year or less, long-term gains for stock held more than one year
  

For the employer:

• Upon employee exercise, the employer can deduct the full bargain element as employee compensation, which is why most employers prefer NSOs over ISOs

ISO Tax Treatment

For the employee:

• ISOs have no ordinary income tax implications at grant or exercise, though they are a preference item for calculating Alternative Minimum Tax (AMT)

• Gains from ISO stock sales are taxed at long-term capital gains rates, provided the holding period requirements are met

• Holding period requirements: shares must not be disposed of within two years of the ISO grant date or within one year of the ISO exercise date

• ISOs must be exercised within three months of leaving the company, or within one year if separation is due to a disability

For the employer:

• Employers receive no preferential tax treatment for properly granted and exercised ISOs. However, any disqualifying dispositions convert the ISO to an NSO, allowing the employer to take applicable tax deductions as if it had granted an NSO

ISO Example

• Year 1: Company grants an option to purchase one share at a strike price of $10 when the stock is worth $10

• Year 2: Stock value rises to $50. Employee exercises the option and pays $10 to purchase one share

• Year 3: Stock value rises to $100. Employee sells the share for $100. The employee has $90 of gain, taxed at the long-term capital gains rate since the holding period requirements were met

Employee Stock Options and Military Service: What to Know

For Guard and Reserve members who hold civilian jobs alongside their military service, employee stock options from a civilian employer can be a valuable component of an overall compensation package. However, there are a few important considerations:

• Deployment and vesting: Extended deployments may affect your ability to meet vesting requirements or exercise options before expiration. Review your ESO plan documents carefully and notify your HR department before deploying to understand your options

• Tax implications during deployment: Combat zone tax exclusions apply to military pay, but ESO income from a civilian employer is still subject to standard tax treatment regardless of deployment status

• Portfolio concentration: With a military pension, TSP, and potentially a civilian 401(k) already in place, concentrating additional funds in a single employer’s stock adds unnecessary risk to what may already be a well-diversified retirement portfolio

What Happens to Your Stock Options When You Leave a Job?

Job changes are increasingly common, and when you leave an employer, you must decide what to do with any vested stock options or shares. Vested options are yours to keep, but unexercised options typically expire within 90 days of your departure, so act quickly if you have options worth exercising.

If you have already converted options into stock, consider transferring those shares to a personal brokerage account at Ally Invest, Charles Schwab, Morgan Stanley, or E*Trade to maintain control of your investment.

Are Employee Stock Options Worth It?

Employee stock options can be a genuinely valuable component of a compensation package, particularly at growing companies where the stock price may appreciate significantly. However, they come with real risks, complex tax implications, and the danger of over-concentration in a single stock.

Before exercising any ESOs, consult with a fee-only financial planner and a tax professional to understand the full financial implications of your specific situation. The difference between an ISO and NSO, the timing of your exercise and sale, and your overall portfolio concentration can all have a significant impact on the after-tax value of your options.