Employee Stock Options (ESO)

Employee Stock OptionsEmployee stock options are the right given to an employee of a public or private company to purchase shares of the company at a given price (Strike Price or Exercise Price). Their purpose is to give the employees an incentive to work hard and stay with the company by giving them the opportunity to become shareholders, thus aligning the interests of the employee and the company.

Employee Stock Option Plans

Stock Option Grant

When granted Employee Stock Options, you will receive a stock option grant. There are 5 important takeaways from this document: the number of options granted, your exercise (strike) price, the type of options you received, your vesting schedule, and your expiration date.

Knowing the number of options granted and the exercise price of your shares is the easiest portion of the grant. You will have the option to purchase X number of shares at the exercise price of $Y. Knowing what type of shares you have, as well as your vesting schedule is a little more complex, but is essential to fully understand your employee stock options.

What type of options do I have, and what does that mean?

Public Company

If you work for a public company, you typically receive either an Employee Stock Purchase Plan (ESPP) or an Employee Stock Option Plan. Under an Employee Stock Purchase Plan, employees have the option (not obligation) to contribute through payroll deductions in order to purchase Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs). The money deducted from your payroll will be used to buy shares of the company at a discounted price (typically around 15% of market value). Stock Options are not to be confused with an Employee Stock Ownership Plan, employees are typically given stock over time with no upfront costs. Once the employee leaves the company, the company will effectively purchase the shares from the employee and assumes control of the stocks.

Private Company

Similarly to a publicly traded company, if you work for a private company, there are 2 types of employee stock options that you can receive in a grant, ISOs or NSOs, and they differ mainly with regards to taxes. Both ISOs and NSOs are taxed based on the spread between the current Fair Market Value (FMV) of the stock and your exercise price at the time of exercise. Neither are taxed until you decide to exercise your options and purchase the stock. You may also receive RSUs, which are not stock options and are treated differently than ISOs or NSOs.

ISOs

Formal Name: Qualified Incentive Stock Options

How they are taxed: When paying taxes on ISOs you are exempt from paying ordinary income tax. However, ISOs are subject to Alternative Minimum Tax (AMT) at exercise. AMT will only be a factor for wealthier tax payers or when the spread between the current FMV and the strike price is large (the AMT exemption recently changed due to 2018 Tax Reform). AMT tax won't be assessed until you pay your taxes the following Spring.

Extra Info: ISOs only apply while you are still employed at the company, and you will have 90 days to exercise after leaving. You may only exercise a maximum value of $100,000 of ISOs per year (calculated by multiplying number of shares by the exercise price).

NSOs

Formal Name: Non-Qualified Stock Options

How they are taxed: NSOs are subject to ordinary income taxes based on the spread between the current FMV and the strike price of the option. As opposed to ISOs, NSO taxes are withheld when exercised.

Extra info: NSOs do not require employment and can be extended well over 90 days.

When receiving ISOs or NSOs from a publicly traded company, they are treated equally except for the fact that they are valued by the current market price of the company stocks. There are many other differences between ISOs and NSOs besides the main aspects highlighted above.

RSUs

Formal Name: Restricted Stock Units

How they are taxed: RSUs will always be taxed at the high ordinary income tax rates. An IPO triggers taxes for RSUs even if you aren't ready to sell the shares.

Extra info: There is no exercise price for RSUs and therefore RSUs are never out of the money, however they do not vest until liquidity is achieved. There are plenty of other pros and cons of Restricted Stock Units compared to stock options.

NEXT: Vesting and Expiration

For more information on how to monetize your private company equity, please contact us at the Employee Stock Option Fund.