Exercising Employee Stock Options (ESO): Guide
For many startups, employee incentive packages have become somewhat of a sensitive topic, as companies struggle to find out the right package for their employees. When it comes to attracting highly-skilled employees and retaining your existing staff, stock options often come up.
However, exercising stock options can prove to be a confusing task for new employees, and even for the employers who are offering them. Some employees don’t even realize that their employee stock options have real value until they have been exercised.
Let’s read about stock options as a part of an employee incentive package.
Stock Options for Employees
In general, employee benefits are expensive for companies who wish to attract good talent in the field. And these employee benefits can range from a variety of options from traditional salary raises, bonuses, extra annual leave or other perks. So there are chances that every employee doesn’t receive all the benefits. In order to curb this situation, employee stock options come in. Let’s understand the meaning of these stock options for employees.
What is a stock option?
Employee stock options are a part of the employee compensation plan. It occurs when a company grants equity ownership to their executives and employees. Granting equity to employees doesn’t mean that the company has given direct access to own the stocks. Rather, it means that they have given the option to purchase the stock later on instead. These stock options help the employees reserve the right to buy the company’s stock at a specified price, the exercise price, over a period of time. All the details about buying the stocks, and the time period of exercising it will be fully detailed in the employee stock option agreement.
Generally, a stock option is issued by the company and can’t be sold, unlike the exchange-listed options or standard listed ones. And the most significant benefit of stock options are realized when the stock of the company rises above the exercise price. In this situation, the holder obtains the company’s stock at a discount. It will be the holder’s decision whether they want to sell the stock immediately for a quick profit or hold onto the stock over time.
Why do companies offer stock options to employees?
What is the main reason to offer stock options to employees? Stock options are issued to attract potential new hires and retain them for a longer period of time. This is just like a way to reward the early employees when and if the company goes public. In short, to motivate them and exercise the company’s equity at a locked-in price. Some fast-growing companies award them as an incentive for employees to work towards growing the value of the company’s shares.
However, these options are often cancelled when the employee leaves the company before the options are fully vested. This vesting period for the options serves as an incentive for employees to stay with the company. The right of voting and dividends are not included in the ESOs.
Let’s suppose you work for a startup that has offered you stock options in their employee incentive plan to retain you as an employee for the long term. In this plan, you can buy 10,000 shares of the company’s stock at the current market price. After that, you will have equity ownership of the company. If the company grows and becomes successful, the share price will rise and you will be able to purchase the shares at a discount. This will serve as a nice employee benefit for your hard work in the company when you sell the shares later for a profit.
How to Exercise a Stock Option
To make sure the performance of the employees is high, and to improve the environment of the workplace, companies grant stock options to employees as a part of their compensation plan. But the question, ‘how will they exercise this option?’ What are the important things they should know before accepting this option from their employer?
What does it mean to exercise an employee stock option?
Exercising an employee stock option means buying the company’s shares at a fixed price according to the guidelines of the stock option agreement. Whenever a company offers stock options to their employees, it means that they are giving the right to buy the shares at a specific price. It doesn’t mean that they are giving you the shares of the company outright.
The price at which you will buy the stocks is also known as the strike price, exercise price, or grant price. Generally, it is the fair market price of the shares at the time you are receiving your options. People usually sell or exercise the stocks when the grant price is lower than the market value of the stock. At that time, this employee stock option is exercised in-the-money, or at a profit.
Let’s take an example: Daniel has received a stock option plan as a part of his compensation package. He received 5,000 options from the company vested over a period of time with a grant (strike) price of $20 per share. But now the market value of that share has increased, and it is currently worth $35. Once the vesting on the options are complete, and Daniel decides to exercise his options, he will get a nice profit of $75,000 (5,000 * $15 profit per share) off the difference of the exercise price and the market value of the company’ shares.
When can I exercise my employee stock options?
So now the question arises, when can you exercise your employee stock options? Generally, startups don’t give the right to employees to exercise their employee stock options right away. The basic aim to offer stock options is to retain and attract highly-skilled employees for the business. In fact, you may have to keep working for the company for a certain amount of time and complete different milestones before you can exercise the options.
The date on which you can earn the right to exercise your stocks is known as the vesting date. In short, the employee has to wait until the stock options, ‘vests’, under the option agreement before they can purchase, and ultimately sell, the stocks. The vesting date is the common feature offered by companies as part of an employee compensation package.
The purpose of the vesting date is to ensure the employee’s commitment to their job position and making the company successful over time. So, when you hit your vesting date, you can exercise your stock options as the benefit will be fully owned by you. However, some companies allow workers to experience the benefit of early exercising before the vesting date. So, if your company grants this, you can exercise your stock options, but they will continue to vest according to the original schedule.
Early Exercise of your Stock Options
Some companies do offer the opportunity for their employees to experience early exercising options. But what exactly does it mean? Does it mean that they don’t need to wait until the vesting period? Let’s read about it.
What is an early exercisable stock option?
Early exercise stock options are just like any other stock options granted to consultants, directors, advisors, or employees. But here, they get the benefit of exercising the stocks before it is fully vested. For instance, let’s say you have received an employee stock option plan for a period of four years. It has been stated under the option agreement that the option holder remains continuously employed or in service on each vesting date.
Usually, the company’s board of directors must approve this first. This is done at the time when the option holders get the stock option plan, and it should be reflected in the option agreement. If the early exercise option doesn’t get approved at that time, the board of directors might approve an amendment to an already existing option to allow for early exercise.
Pros and Cons of early exercising
As stated above, early exercising is the right to exercise the company’s stocks before they get vested. But there are some pros and cons of this early exercising benefit.
An early exercising feature includes both incentive stock options (ISOs) and nonqualified stock options (NSOs), but they work differently. Early exercising could benefit you in a few ways:
- When you have incentive stock option plans, early exercising can help to qualify for favorable tax treatment. In order to qualify for this benefit, you need to keep your shares for at least two years after the option grant date, and one year after exercising.
- When you have NSOs, early exercising helps start your holding period sooner, so when you sell, you may pay the lower long-term capital gains tax.
When you exercise your stock options at the time they are granted, you wouldn’t have to deal with additional taxes. Because you have bought them at fair market value by assuming that there’s no spread between what the stock is currently worth and how much you paid.
Disclaimer: Always remember that you must file an 83(b) election within 30 days of exercising to take advantage of this potentially favorable tax treatment. If you miss this deadline, there could be serious ramifications.
However, there are cons of using early exercising options:
- If you are exercising your early exercise option plan, you can’t sell some of your stocks to pay the price of your shares. In that case, you need to use your own money.
- There is no guarantee that the value of your shares will increase. However, when you wait for a one-year vesting cliff, then you get an idea about whether your purchased stocks will rise or not.
- After early exercise, you leave your company, but before your mentioned vesting date, then the company reserves the right to repurchase your early-exercised, though unvested stock.
4 Common Practices to Consider When You Exercise Stock Options
Exercising stock options means buying the company’s stock at the grant price fixed by the company under the option agreement. As an employee of the company, you have to follow all the regulations stated in the agreement to exercise your stock option. Below we have shared the main four strategies that will help you to exercise your stock options.
Hold Your Stock Options
When you buy the company’s stock, it will be your decision when you want to sell it. If you think that the price of the stock will rise over a certain period, then you can take benefit of the long-term nature of the option. In fact, you can also wait to exercise them until the market price of the issued stock exceeds the grant price. But always remember that stock options will expire after a time period, and after that, they will have no value in the market.
Initiate an Exercise-and-Hold Transaction (cash for stock)
The second strategy that you can apply while exercising your stock options is the exercise and hold the transaction. It means that you can buy the shares of the company’s stock and then hold it until you desire. This strategy will give the right for maximum investment in the company stock.
Initiate an Exercise-and-Sell-to-Cover Transaction
In this strategy, you purchase the option shares and then immediately sell enough of the shares just to cover the stock option cost, brokerage commissions, fees, and taxes. The proceeds you get from an exercise-and-sell-to-cover transaction will be shares of stock. So, you will receive a residual amount in cash.
Initiate an Exercise-and-Sell Transaction (cashless)
You may exercise your stock option to purchase the company’s stocks and then sell it at the same time without adding your own cash. The proceeds you receive from an exercise-and-sell transaction will be equal to the fair market price minus the grant price and the required brokerage commissions, fees and tax withholding.
By now, you may have a better idea about exercising employee stock options and how it works for a company. In this way, you can keep all the employees motivated while their interest is centered around the success of the company.
If you are setting up a business and are looking to grow it faster, consider using stock options as a viable method for recruiting highly-skilled employees. Offering your employees the taste of being owners of the company’s stocks would do wonders both for you and your company.
But in order to keep a track record of everything, you need to have a cap table application that is reliable and easy to use. And here, Eqvista can help you! Our app is free to try. So, try it and check for yourself how our cap table app can help keep track of all your company’s equity and details of the exercising of your employee stock options, all in one place.