Employee stock options: What they are and how they work

Here's how employee stock options work

Chart with varying trends

Employee stock options are a great way to attract and retain top talent, especially for startups and growing companies with limited cash flow. Employees often feel incentivized to help the business do well when they know they’ll share in the company’s future financial success. Additionally, employers can offer more competitive compensation packages without committing to higher salaries.

Not sure if this type of employee benefit is right for your company? Let’s explore how employee stock options work so you can decide. 

Want to see the Oyster platform in action? Book a demo and we promise to show you all the features that’ll make your People Ops team go whoa.

What are employee stock options?

A stock, also known as traded equity or a share, represents a unit of ownership in a company. When you own stock in a company, you essentially become a partial owner, giving you a claim to the business’s assets and earnings.

Several factors influence the value of a stock: industry trends, overall market conditions, and the company’s financial performance. If the business performs well, its stock value should increase. Stockholders can then sell their shares for a profit.

Offering employee stock options as a benefit of employment gives your workers the option to purchase a certain number of shares at a set price, also known as the strike price. When the option contract is issued, the strike price is typically lower than the stock price the public would pay. 

Although they’re closely related, stock options differ from equity or stock grants; it all comes down to choice. When you give your workers equity, the shares are part of their total compensation. There’s usually no vesting schedule, so they can cash out whenever they want. Stock grants operate similarly but do typically come with a vesting schedule.

On the other hand, stock options don’t give employees any ownership in the company until they exercise that option. They have the right—but not the obligation—to become partial owners, and they’ll usually need to wait till the end of a vesting period before they can cash out their shares.

How do employee stock options work?

Imagine your company grants an employee 1,000 stock options at a strike price of $5 per share. The employee exercises that option and spends $5,000 on shares. Then, the market price hits $25 per share, and they have $25,000 in stock.

Now, say the employee sells their $25,000 in company stock. After subtracting the $5,000 they put in, they’ve earned a $20,000 profit. That figure represents the employee’s capital gains—the profit earned from selling stock (or any other asset) for more money than the purchase price.

Remember that vesting schedule we mentioned earlier? That’s an essential part of the equation. Most stock options come with a vesting period—the employee must earn the right to exercise their options over a set period. The vesting period incentivizes employees to stay with the company and contribute to its long-term success.

For employers, this commitment is one of the most attractive elements of employee stock options. Here are two more reasons you might consider giving your workers the chance to buy shares:

  • Cost-effective compensation: Offering employee stock options is a cost-effective way to create a competitive compensation package without spending as much money upfront.
  • Tax benefits: You might get tax deductions for the expense of granting stock options to employees, which would offset some of the costs of an equity compensation plan.

There is one potential drawback: Issuing new shares of stock to employees dilutes the ownership of the existing shareholders. However, many organizations—especially startups and growth-stage companies—feel the tradeoff is worth making because it allows them to pay less for better talent.

Types of employee stock options

Stock options aren’t one-size-fits-all. You have several options to choose from, each with its own features and tax implications.

Incentive stock options

Incentive stock options (ISOs) give employees based in the United States a tax advantage because they can defer taxes on their capital gains until they sell their shares. They may also qualify for capital gains tax treatment instead of paying ordinary income tax on the money they make.

Unfortunately, the tax advantages of ISOs don’t apply to workers based in other countries, and ISOs may trigger the alternative minimum tax for U.S. employees.

Non-qualified stock options

You can grant non-qualified stock options (NSOs) to anyone, regardless of location or employment status. They’re more flexible than ISOs but don’t offer the same tax breaks. In the U.S., taxes are typically due when employees exercise stock options, and the gains they get from selling the shares are also subject to capital gains tax.

Restricted stock options

Restricted stock options (RSOs) are gradually granted to workers over a set period—a year, two years, or whatever period your company settles on. Employees who hold RSOs aren’t required to buy the shares. If they do, they’ll usually face restrictions on selling them until the vesting period ends.

Employee stock purchase plans

An employee stock purchase plan (ESPP) allows employees to purchase company stock at a discounted price through payroll deductions. These plans often have specific offering periods and limit the amount of stock employees can buy.

Performance shares

Performance shares are a type of stock grant tied to specific performance goals, such as revenue targets or profitability milestones. Employees only receive the shares if the company meets its goals.

Phantom stock

Phantom stock doesn’t represent actual ownership in the company but mirrors the value of company shares. Employees receive payments based on the value of the phantom stock, usually upon a triggering event like retirement or termination. Some companies use virtual stock option plans to simulate equity compensation without issuing actual shares.

The challenges of granting stock options to international employees

Global workforces have become quite common, which means you may have a mix of international and U.S.-based employees. A global team presents some complexities to ensure compliance and avoid unintended consequences for you and your employees. Here’s a look at the challenges you need to consider.

Adhering to tax laws and local regulations

Tax treatment of stock options depends on the worker’s home country. For example, the tax code in the U.S. is different from that of France, so an employee in France would need to research their specific tax implications.

Depending on the country, employers may have tax withholding requirements. Failure to adhere to such requirements can result in costly penalties.

Creating an international employee stock ownership plan

You can use an international employee stock ownership plan (ESOP) to grant equity in your business to employees. The structure will vary based on your company’s location and the type of stock options you wish to grant, making creating an ESOP tricky.

Choosing the right equity incentive

To choose the best equity compensation plan for your company, you’ll need to weigh the pros and cons of each type for you and your employees. For example, ISOs are tax-advantaged for U.S. employees but don’t offer the same benefits to workers in other countries. NSOs are more universally applicable but may come with different tax implications depending on the employee’s location.

It’s not an easy path to navigate, but partnering with an expert like Oyster can help.

Creating an employee stock option plan

Here are some of the steps you’ll need to take to offer stock options to your employees:

  1. Adopt or create an employee stock option plan.
  2. Get a 409A valuation to determine the fair market value of your company stock (crucial for tax purposes).
  3. Set a strike price that aligns with the fair market value of your shares.
  4. Decide on a vesting schedule.
  5. Determine how long employees have to exercise their options after they leave the company. 

Try Oyster’s equity assessment tool

Employee stock options are a valuable employee benefit, but incorporating stocks into your workers’ total rewards is hard to do without expert help. Oyster’s equity compensation assessment tool simplifies the process of determining the fair market value of your shares. It helps you develop a plan that meets your needs—and the needs of your employees.

Book a demo today to see how Oyster can help you hire, pay, and manage global talent in over 180 countries.

About Oyster

Oyster is a global employment platform designed to enable visionary HR leaders to find, engage, pay, manage, develop, and take care of a thriving distributed workforce. Oyster lets growing companies give valued international team members the experience they deserve, without the usual headaches and expense.

Oyster enables hiring anywhere in the world—with reliable, compliant payroll, and great local benefits and perks.

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