Employee Stock Options

Employee stock options aren't the same as other types of options that are typically bought and sold on the exchanges by traders. They are, however, increasingly being used by both private and public companies, so it is a useful topic to understand if you ever are offered them by your employer.

These options are basically a form of remuneration for employees, and can be given by the employer for a number of reasons. On this page we provide more information about them, how they work, and what you can do with them.

Employee Stock Options & How They Work

Employee stock options are basically a form of call options because they give you the right to buy stock in the company that you work for at a strike price, at some point in the future. If you are given them by your employer, they will have a fixed price at which you can purchase company shares. If the company shares go up in value, then you can buy them at the pre-agreed price and effectively make an instant profit.

These work as good incentives to the employers, as the employers only get any reward out of them if company stock goes up in price. This firstly provides a good motivation to the employer to help make the company a success, and also mean the company only incurs a cost if the company is doing well.

Employee stock options can be given out in a variety of ways and for a number of different reasons. For example, a company trying to recruit someone they really wanted working for them could offer them as an incentive to join the company. They could also be offered to existing employees as part of their salary, or as a bonus for hitting specific performance targets.

There are certain terms relating to employee stock options that you might like to understand. The holder is the person that owns them. So you are the holder of any options that you are given. The strike price is the price at which the holder is entitled to buy the stock at once the contract allows. The contract will also include an expiration date; the date by which the employee must exercise their option to buy the stock if they wish to.

Most contracts of this type include a vesting period; during this period the holder is not able to exercise their right to purchase stock. Once the contract allows the holder to exercise, they become known as vested options. The contract will usually also include a waiting period, which stipulates a period during which shares bought through exercising cannot be sold on the open market.

Most employers issue employee stock options with a vested period as a means of keeping the employees at the company. They automatically expire if the holder decides to leave the company, so they serve their purpose in that respect. Often, companies will issue contracts with a vesting schedule that allows the employee to buy stock every so often over a long period. For example, a company may issue stock options for 3000 shares where the employee can buy 500 shares every six months over a 3 year period.

The waiting period in employee stock options can vary greatly depending on a number of factors. Waiting periods give the employers some control over when shares in their company are going to be sold on the stock markets. They can range from just a few days to several months.

Advantages & Disadvantages of Employee Stock Options

The biggest advantage of employee stock options is that they will typically be more valuable than an alternative that might be offered in cash. For employees working in companies that have the potential to experience rapid growth, they can end being worth much more money than they could have expected to earn through traditional remuneration. Start-up companies in the certain industries are particularly likely to offer them, and many employees in such companies have made millions of dollars when the company ends up becoming a real success.

There are of course some disadvantages too. The benefits of them are not always immediately realizable – if there is a long vesting period for example, or a lengthy waiting period. This might not be a problem for an employee making a good regular salary, but if stock options make up a big proportion of an employee’s remuneration it could be an issue. Employee stock options also have the potential to be worthless. For example, if the employee should leave the company then they would expire. Alternatively the company share price could drop well below the strike price meaning there was no value in them.

However, the benefits probably outweigh the disadvantages, particularly because there are often tax advantages involved too.  These advantages can depend on exactly how the options are issued and the local tax legislation. If you are offered the choice between employee stock options and a more standard form of monetary compensation, then you need to look at all the factors involved and determine what is best for you and your own personal set of circumstances.