Employee Stock Option (ESO)

What is an Employee Stock Option (ESO)?

An employee stock option (ESO) is a form of financial equity compensation that is offered to employees and executives by their organization. The stock options offered come in the form of regular call options and allow the employee or executive to purchase their organization’s stocks at a specified price and time. Before the stock option is finalized, the terms and conditions are discussed and signed off on in an employee stock option agreement.

Forms of Stock Options

In the case of stock options, there are two primary forms:

1. Incentive Stock Options (ISOs)

Sometimes referred to as qualified or statutory options, incentive stock options (ISOs) are stock options that are mainly offered to important employees or upper management. Incentive stock options are given preferential tax treatment. It is because incentive stock options profits are treated as long-term capital gain under the Internal Revenue Service (IRS).

2. Non-Qualified Stock Options (NSOs)

On a different note, non-qualified stock options (NSOs) are stock options that are offered to all levels of employment. Non-qualified stock options are not given preferential tax treatment. It is because non-qualified stock options profits are taxed as ordinary income tax.

Stock Option Tax Implications

It is crucial to know the tax implications of stock options in order to receive the largest financial gain. Shown below are the tax implications of stock options for specific events:

Forms of Equity Compensation

Equity compensation is a financial benefit that is offered to employees by management. Employee stock options are one form of equity compensation; listed below are the other forms of equity compensation that may be offered to employees.

• Restricted Stock Grants: They give employees the option to receive shares only if a specific criterion is met. In such a case, the specific criterion could be seen as the completion of performance objectives, years spent with the company, etc.
• Stock Appreciation Rights (ASRs): They give the employee the right to increase the value of a specified number of shares.
• Employee Stock Purchase Plans: They allow the employee to purchase organizational shares at a discount.
• Phantom Stocks: They pay a future cash bonus that is equal to the value of a defined number of shares. The legal transfer of share ownership does not usually take place with phantom stocks.

Apart from employee stock options, it is always beneficial to seek information on the wide array of other options that may be offered by management.

Other Types of Stock Options Offered by Companies

Apart from the forms of equity compensation mentioned above, although unlikely, companies can offer two other forms of stock options.

1. Restricted Stock Units (RSUs)

A restricted stock unit is an employer’s promise to provide shares of the company’s stock in the future if specific criteria are met.

2. Restricted Stock Awards (RSAs)

A restricted stock award is similar to a restricted stock unit, except the shares can be immediately purchased on the day that they are granted.

Advantages of Offering Employee Stock Options

Listed below are the primary advantages of offering employee stock options.

• Employee stock options make compensation packages more attractive
• They are a cost-effective company benefit
• Increases employee retention
• Gives employees “ownership” in the company, allowing them to feel more connected to the organization as a whole
• Employees are motivated to work harder. When the business is doing better financially, so is the employees’ stock
• Potential tax benefits

As a whole, offering employee stock options allows the employees to feel more connected to the business and more motivated to work harder, so the organization does better.

Disadvantages of Offering Employee Stock Options

Listed below are the primary advantages of offering employee stock options.

• Complicated tax implications for the employees.
• Stock options can be difficult to value.
• Individual employees rely on the effort put forward by their peers for organizational success, which can cause potential conflict.
• Stock options can result in high compensation for executives, even if the business is financially under-achieving.
• Over the long run, dilution can be extremely costly to shareholders.

As a whole, offering employee stock options can cause some negative implications. Valuation of stock options can be difficult, and executives can financially prosper even when the organization is not reaching their goals.

Related Readings

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Cliff Vesting
• Employee Stock Ownership Plan (ESOP)
• Non-Qualified Deferred Compensation (NQDC)
• Non-Qualified Stock Option (NSO)
• Remuneration
• See all career resources