Employee Stock Options: Friend or Foe?
It depends on who is asking - whether you are an employee with a promising start-up or an entrepreneur who wants to attract and retain the best talent. There are pros and cons for both parties, which we aim to clarify in this article.
First and foremost, what is an employee stock option, and how does it differ from financial options?
Employee stock option is a label that refers to compensation contracts between an employer and an employee that carries some characteristics of financial options. They are an internal agreement providing the possibility to participate in the company's share capital, granted by the company to an employee as part of the employee's remuneration package.
These non-standard contracts exist between the employee and the employer. The employer is liable for delivering a certain number of company shares when and if the employee exercises the employee stock options. The contract length varies and often carries terms that may change depending on the employer and the employment status. Similar to financial options, this agreement grants the employee eligibility to purchase a pre-determined amount of stock at a pre-determined price and a pre-determined date.
Many companies use employee stock options plans to retain, reward, and attract employees, giving employees an incentive to work in ways that will boost the company's valuation. The employee could exercise the option, pay the exercise price, and be issued ordinary shares in the company. As a result, the employee would experience a direct financial benefit from the difference between the market valuation and the exercise price of the employee's stock options.
Stock options are also used as GOLDEN HANDCUFFS if their value has increased drastically. An employee leaving the company would also effectively be leaving behind a large amount of potential cash, subject to the restrictions as defined by the company. These restrictions, such as vesting and non-transferring, attempt to align the employee's interests with those of the business owners.
Employee stock options may have some of the following differences from standardised, exchange-traded financial options:
Exercise price: The exercise price is non-standardized and is usually the current price of the company stock at the time of issue.
Quantity: Standardized stock options typically have 100 shares per contract. Employee stock options have some non-standardized amounts.
Vesting: Some or all options may require that the employee continue to be employed by the company for a specified term of years before "vesting" (i.e. selling or transferring the stock or options). Vesting may be granted all at once ("cliff vesting") or over a period of time ("graded vesting").
Liquidity: Private companies' employee stock options are not liquid, as they do not trade publicly.
Duration: Employee stock options usually have a maximum maturity that far exceeds the maturity of standardised options.
Non-transferable: With few exceptions, employee stock options are generally not transferable and must either be exercised or allowed to expire worthless on the expiration day.
Over the counter: Unlike exchange-traded financial options, employee stock options are private contracts between employers and employees. As a result, the two parties are responsible for arranging the clearing and settlement of any resulting transaction. In addition, the employee has exposure to the company's credit risk. If the company cannot deliver the stock against the option contract upon exercise, the employee may have limited recourse. Exchange-traded options guarantee the fulfilment of the option contract.
Taxation: There are differences in the tax treatment of employee stock options with their use as compensation. These vary by country of issue, but they are generally tax-advantaged compared to standardised options. It is advisable to consult with a tax advisor if you are part of an employee stock option plan with a fast-growing company.
You are a business owner who awards employee stock options
To attract and retain the best talent for your company, you need to have a competitive compensation package, which should include stock options and base salaries, and other financial and fringe benefits.
If your company is performing well, giving employees stock options may prevent them from leaving for another job opportunity. Stock options generally are vested on a periodical basis, and the employee has to continue working for the company to become a shareholder in the company. This approach motivates the employees to go the extra mile for the company to perform better and also reduce employee turnover.
Remuneration packages can get competitive, especially if you're trying to attract and retain the top talent. Offering stock options to employees is a cost-effective way to add something different to the mix without racking up a hefty bill for the company.
On the other side of the coin, stock options are dilutive for the business owners and any institution or person that has invested in the company.
You are an employee with stock options.
It is essential to know that an option is NOT equity in the company!
An option is simply the right to buy shares in the company at a pre-determined price in the future. If the company can grow and increase in value, employee stock options can become valuable.
Options are earned over time and not when they are awarded. You need to work at least a year to exercise a portion of your employee stock options, and it usually takes 3-4 years for the initial options to be vested/exercised fully. If you leave the company without exercising your options, you lose the opportunity. When you buy your stock, you owe tax on the value of the stock you BUY, not what you PAY. You may only have paid a $1 strike price, but what if it's at a $100 share price? You owe the government capital gains tax on the $100 in cash, no matter how uncertain or illiquid that stock is.
If you are fortunate enough to be in a position to be presented with stock options, make sure you are Up To Speed with the ins and outs of Stock Options. Primarily, understand the conditions for you to exercise the options and whether the goals linked to them are realistically achievable.
If you have any questions on any of the subjects discussed in the article, please do not hesitate to contact the Levantine & Co team.