Employee Stock Option Plan Details

When an employee is enrolled in a stock option plan by their employer, a certain amount of their salary is deducted and automatically used to purchase stocks. After a preplanned period, say six months, the employee’s contributions are converted into company stocks. The number of stocks that an employee can purchase is equivalent to the amount deducted. An employee stock option plan is only available in publicly traded companies.

Employee stock option plans hold great significance to both the employer and the employee. The most notable significance is that they can hold huge financial benefits for the employee. Profits from the stocks can easily surpass an employee’s salary and quickly turn them into a millionaire. Of course, this is also dependent on how fast the company is growing.

Another benefit of the employee stock option plan is that if the employer cannot pay market-rate salaries, they can offer their employees these options instead of a salary. While this will work for the employer, it can often be a gamble for the employee if it is a start-up and it goes belly up.

Example of Employee Stock Options

Here is how an employee stock option works. First of all, stock options offer employees an assured amount of stocks for a specific price during a predetermined period. Typically, these options have an expiration date; otherwise, they are rendered worthless.

For instance, an employee can purchase 1,000 stocks at the rate of $150 per stock. This price is known as the strike price or the exercise price. There is a caveat; however, the employee can only exercise these options once they are vested.

An employer may decide to set up a multi-year vesting program where an employee will be vested in 200 stocks in the first year; then, this amount may double in the next year. Each year, the employee will be able to buy or exercise the stocks offered. This vesting program aims to incentivize the employee to work longer in the company.

Types of Employee Stock Options

There are two types of Employee Stock Options;

Incentive Stock Options (ISOs)

Incentive Stock Options are a type of employee stock option which qualifies for exceptional tax treatment as long as you hold on to your stock for at least two years after purchase or exercise. The IRS treats them as long-term capital gains, hence the preferential tax treatment. However, when selling these options, you will be liable to pay a tax. These stock options are usually only offered to top-tier staff or management.

Non-Qualified Stock Options (NSOs)

These stocks are offered to all employees in a company, board members, including consultants. The profits gained on these stocks are usually considered ordinary income, and the same tax applies. Another name for these stock options is Non-Statutory Stock Options.