What Are Employee Stock Options and How Do They Work?

While you might enjoy your job, there aren’t many people who wake every day and go to work just because they like it. Unless you’re financially independent, there’s a good chance one of your primary motivations for working is earning a paycheck and benefits.

With the current hot job market in the US, there's plenty of competition for talented employees.

To draw their interest, employers must offer a competitive salary and benefits package. Corporate employers can include several things in a compensation package, such as:

1. Wages. Monetary compensation in the form of a base salary, hourly pay rate, contract payments, commissions, bonuses, and cash contributions to a retirement plan.
2. Employee Benefits. Examples include health/dental insurance, life insurance, health club membership, vacation days, sick days with pay, access to a company car, childcare reimbursement, expense account, and college tuition reimbursement.
3. Long-term Incentives. Some employees are receiving employee stock options. This, by definition, allows the employee to purchase the company's stock at a future date. This is very common at the executive level of employment, or at small or private start-ups.

Employee Stock Options and How They Work

When a company awards an employee with stock options, they're giving the employee the right to purchase the company's stock in the future.

The employee stock option typically includes the following information:

Number of Shares – This is the number of shares they allow an employee to purchase.

Strike Price – This is the price the employee must pay for the stock when they make the stock purchase. Note: The strike price is usually lower than the retail market rate.

Market Price – This is the actual retail market price for the stock at the time the option is issued. If the strike price is less than this amount, the company is clearly offering the employee a discount on the stock's actual value.

Issue Date – This is the date the stock option was awarded to the employee.

Vesting Date – This is the date the employee qualifies to exercise their stock option. Usually, it's tied to a specific term of employment – often the employee's first-anniversary date.

Expiration Date – Employee stock options provide the employee with a date they have to exercise the option by or lose the right to use the said stock option.

Exercise Date – This is the actual date the employee chooses to exercise their stock option and pay for the stock.

How The Process Works

To help you better understand the employee stock option concept, an example of how the process works can be instrumental.

Let's start by assuming your new employer gives you an employee stock option after you have cleared the company's requisite probationary period. At that time, they give you a stock option, which reads as follows:

You (your name) are being awarded the right to purchase 1,000 shares of Company XYZ at a strike price of $5 per share. The vesting date will be exactly one year from the start date of your employment. The current retail price of the stock sits at $7. Upon reaching your vesting date, you will have six months to exercise your option. Failure to do so will result in expiration or forfeiture of the stock option.

When you reach your first-anniversary date, you notice the retail price of the stock is $8. You are now vested and decide you want to exercise the stock option.

At that point, you need to make arrangements to pay $5,000 for the 1,000 shares.

Paying for Them

While some people will pay cash for the stock, there are usually other payment options available for people who do not have the required amount in cash, including the:

• Exercise Without Cash Method. If the stock's retail price is higher than the strike price, this is an excellent option.

You can immediately sell enough stock to cover the payment amount. If coordinated through a broker, the exercising of the option and selling of the stock can be facilitated simultaneously. This prevents you from having to pay out-of-pocket for the stock.

Under this scenario, you would need to sell 625 shares at the retail $8 price to raise the $5,000. You would then hold 375 shares bought and paid for in full.

• Stock Swap Method. At the time you decide to exercise your employee stock option, you can offer to swap shares you already own in the company to facilitate the transaction.

Let's say you already own 1,000 shares from a prior transaction. You can give the company a stock certificate for the 625 shares already owned as payment in full for the new 1,000 shares. You would then hold 1,375 shares in total, without paying out any money.

Advantages and Disadvantages of Employee Stock Options

As the employee, you would certainly want to participate in a program offering stock options as compensation if it provides you any benefits.

The most significant benefit is the opportunity to pick up additional compensation if the actual market price is higher than your strike price.

The other advantage you would realize would be the opportunity to purchase stock without having to pay a broker's fee until you decide to start selling the stock.

For the employer, there are also a couple of advantages, the ability to:

1. Offer a form of compensation not requiring a cash outlay
2. Use employee stock options to help motivate people to join and stay with the organization

If profits drive stock prices, invested employees often work a little harder and longer to make the company more profitable.

As for the disadvantages, you'll have income tax exposure when you decide to start selling shares. If you sell within the first year, you will get hit with a tax bill for short-term capital gains.

Of course, everything matters little if the market stock price never exceeds the strike price prior to the stock option reaching its expiration date. A perk with no value is a disadvantage.

For the employer, a stock option is only a motivating factor if it gives the employee something of value at some point in time. If the stock option never reaches the point of profitability in the employee's eyes, the offer could end up being demotivating instead.

Final Thoughts

While an employee stock option has great appeal, there can be complications. If offered the chance, you should absolutely consider getting involved in any opportunity an employer provides to participate in partial ownership of the company.

At the absolute least, it's a great way to create a little extra compensation for your loyalty and hard work.

With that said, you still need to exercise sound fiscal responsibility in the decisions you make, including learning all about stock options and investing before deciding to get involved in an employer's stock option plan.