If you are working in a fast-growing company or a startup, there's a good chance you've heard of employee stock options. They’re often offered as part of your compensation but what do they really mean for your financial future? Put simply, employee stock options (ESOs) give you the right to buy shares in your company at a fixed price. If your company does well, those shares could be worth a lot more than what you paid for them. It can be but there are a few things you should know before signing on.
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What are employee stock options?
Think of ESOs as a way of staying with the company and sharing the success and growth in the future. Under an Employee Stock Option Scheme (ESOS), you are given the option not the obligation to buy company shares at a set price after a certain time (called the vesting period). This fixed price is usually lower than the market price, so if your company’s value goes up, you can profit from the difference.
How does the Employee Stock Option Scheme (ESOS) work?
The Employee Stock Option Scheme (ESOS) is typically carried out in three main stages from granting to exercising the options. Here is how the process unfolds:
- Granting of options: This is the first stage, where the company offers eligible employees the right (but not the obligation) to buy a certain number of shares at a predetermined price, known as the grant or exercise price. No payment is made at this stage.
- Vesting period: After options are granted, employees must complete a specific duration called the vesting period. This ensures long-term commitment and aligns employee goals with company growth. Only after completing this period do employees earn the right to exercise their options.
- Exercise of options: Once vested, employees can choose to exercise their options i.e., buy the company’s shares at the pre-fixed exercise price, even if the market price is higher. This allows them to benefit from the price difference and realise potential financial gains.
Types of employee stock options
Not all ESOs are created equal. Here is a breakdown of the common types:
- Incentive Stock Options (ISOs): Usually given to full-time employees. If held for long enough, profits may be taxed at a lower rate.
- Non-Qualified Stock Options (NSOs): Can be given to employees, advisors or directors, but come with higher tax implications.
- Restricted Stock Units (RSUs): These aren’t really options – you don’t have to buy them. Instead, you receive shares (or their cash value) once certain conditions are met.
- Stock Appreciation Rights (SARs): You benefit from the rise in the company’s share price, without needing to buy the shares yourself.
