For years, many companies offered stock options to high-ranking executives and a few select employees as a reward for their contributions to the company. Since the 1980s, the number of companies offering employee stock options has increased 9-fold.
And it’s not just top staff members who are receiving the benefits. More and more, companies are recognizing the advantages of issuing stock options to their team to improve company loyalty and to create a tighter bond with their employees.
What are stock options, you ask? And why are they good for the company and for employees?
Read more to discover everything you need to know about employee stock options now.
What Are Employee Stock Options?
An employee stock option is a contractual right of an employee to purchase a predetermined number of company stock shares. The shares are sold at a specified price, usually a discounted rate, which is called the exercise price.
The company issues the shares to the employee according to a defined timeline. The options have a vesting date, meaning the employee must work at the company for a defined period of time before they qualify to receive the full number of shares.
An employee can only exercise their options between the vesting date and the expiration date, upon which time the options are no longer redeemable.
Why Do Startups Offer Stock Options to Employees?
Here are the most common reasons small businesses offer employee stock options:
Attract the Best Talent
The main reason businesses offer stock options is to snag top-notch talent. The market for skilled and experienced employees is extremely competitive.
Even during a down economy, companies want top talent to gain a competitive advantage in their industries. Offering stock options is an important way to attract talented staff and keep them long-term.
Foster Dedicated and Loyal Employees
Experts agree that employees with company stock are more motivated and dedicated to the companies they work for. When employees exercise their stock options, they become even more focused on the company’s success.
It makes sense; an employee’s stock value is a direct result of the company’s performance. Coming full circle, company performance is a product of the employee’s valued contributions. As the company and the employee are partners in the success of the company, both sides receive the mutual benefits of success.
Attractive and Cost-Effective Benefit
The cost of employee benefits is always on the rise. As such, companies are always looking for valuable benefit programs they can offer for a moderate cost. Stock option plans fit the bill perfectly as a strong employee benefit that doesn’t break the bank for the company.
Even though stock options are not a substitute for pay increases, they are an attractive component of a well-rounded benefits package that employees and prospective employees value.
Types of Stock Options
There are two primary types of stock options: nonqualified stock options and incentive stock options. These two options differ in the way income tax is to be paid on the earnings.
A nonqualified stock option (NSO) requires you to pay ordinary income tax on the difference between the grant price (the stock price when you purchase) and the exercise price (the price when you “cash in” your options).
Let’s say your company offers you 1,000 shares at a discount rate of $50 per share. The employer will likely offer a vesting schedule. So in this example, you can buy 200 shares every year for five years. You are vested in 200 shares after one year, 400 shares after two years, and so on until the 1,000 shares are purchased.
The stock performs well and you exercise your options before the expiration date for $75 per share. Since you are exercising nonqualified stock options, you must pay ordinary income tax on the difference between the grant price ($50) and the exercise price ($75). in this case, that amounts to $25 per share or $25,000.
Incentive stock options (ISO) come with a valuable tax benefit. When you exercise your ISOs, you are taxed at the more favorable capital gains rate instead of the ordinary income tax rate.
Let’s try another example: A single woman earning $75,000 invests in $50,000 of incentive stock options. When she exercises her options five years later, the value is $100,000.
In this case, she must pay capital gains tax on $50,000 of profitable earnings. Since her $75,000 income puts her in the 15% capital gains tax bracket, she will only owe the IRS $7,500.
The Bottom Line
Employee stock options are a valuable piece of an employee benefits plan. Stock options give the company the opportunity to offer a valuable benefit for a moderate price. They also help to motivate employees and foster dedication and loyalty.
For the employee, it’s a fantastic way to get stock options at a discounted rate. Often, the value of the stock is already higher than the grant price so the employee is immediately “in the money.” Providing the company stock performs well, employees can exercise their options to put a down payment on a home, pay off student loans or retire early.
Keep reading this blog for more smart ways to grow the value of your business and your personal wealth.