posted on 06-06-2019

Employee Stock Options (ESOs)

Updated September 18, 2019

What are Employee Stock Options (ESOs)?

Employee stock options (ESOs) are  call options on a company's common stock granted to a select group of its employees. Certain restrictions on the option provide a financial incentive for employees to align their goals with those of the company's shareholders. 

How Do Employee Stock Options (ESOs) Work?

If an employee working for company XYZ gets an option on 100 XYZ shares at $10 and XYZ's stock price goes up to $20, the employee can exercise the option and buy the 100 XYZ shares at the $10 strike price, sell them on the market for $20 each, and pocket the $1,000 difference ($2,000 - $1,000 = $1,000). If XYZ's stock never goes above the $10 strike price, the employee lets the option expire at no real cost to themselves.

There are two types of employee stock options: incentive stock options (ISO's) and nonqualified stock options (NQSO's). ISO's are usually given to upper management while NQSO's are generally provided to other employees or service providers. While NQSO's can be obtained at a discount to the stock value, ISO's generally enjoy more favorable tax treatment. The employee does not have to provide any cash to obtain these stocks.

Why Do Employee Stock Options (ESOs) Matter?

Employee stock options can be very different from more traditional options contracts. Some basic differences are a non-standardized strike price (often the current price of the company's stock at the time of issue), vesting (number of shares available to be exercised increases the longer the employee works for the company), and a significantly longer date until expiration. Also, ESOs usually can't be traded, and may be worthless on expiration day. Lastly, most ESOs aren't taxed until they're exercised, if at all.

Although ESOs were traditionally inexpensive to the employer since they were not expensed on a company’s income statement at the time of issuance, there have been strong voices within the business community arguing that they should be expensed.