Employee stock options (ESO) are call options – or options to obtain assets at an settled price on or before a specific date – on the common stock of a company. It is granted to employees as part of their remuneration package.
An employee stock option refers to an offer by an employer to an employee. It gives them the right to buy a certain number of shares at an agreed-upon price in a certain period. Typically, the price shares are lower than the market value and are not traded on an exchange. The employee has no obligation to exercise their option.
Employees also typically have to wait for some time – known as the vesting period – before they can exercise their options. Early exercises usually result in penalties for the employees exercising their options. It is the obligation of the employer to provide the employee with equity whenever they wish to exercise their option, provided it is within the agreed upon period.
Reasons for issuing employee stock options
Employee stock options provide a win-win situation for businesses and employees because they offer several benefits to both. This has seen employee stock options being leveraged by more businesses, both large and small, in an effort to increase their competitive advantage.
Today, even small businesses are using ESO to attract and retain employees. Employee stock options also serve to align the interests of shareholders with those of employees. Providing employees with options has resulted in the success of many start-ups and small businesses. In these companies, many key employees are attracted primarily to ESO.
Benefits of employee stock options (to businesses)
Businesses use employee stock options to attract and retain talented employees. It makes employees owners of the business and interested in seeing it grow. It also gives employees reason to watch the stock price and its rise. This helps make employees more productive and personally vested in the success of the business.
Employee stock options increase employee loyalty. These options entice employees to stay with a company longer. This saves the company resources in talent acquisition costs. It motivates employees. Employees with options are more dedicated because they are more invested in the business.
Another way businesses can leverage stock options to increase employee retention is through vesting provisions. Employers can retain employees longer by requiring that their staff remain in employed for a given period before the stock options can be exercised and the shares sold. Employees are dissuaded by penalties and will not often exercise their options early.
Stock options ensure high liquidity and cash flow in a business. Salaries and wages for employees with options are lower than when only monetary remuneration is involved. This results in lower operational overheads. In addition, employees typically have to buy options, providing the business with revenue.
Benefits of employee stock options (to employees)
Options are preferred as a form of remuneration by employees due to several factors. They provide a way for employees to benefit in the long run for the effort and time they invest in a business. This means they do not miss out on the wealth they create. It enables them to benefit directly when the business they work for grows and increases wealth.
For most start-ups and small businesses, funds are usually limited and it is hard to attract talented employees strictly on salaries. Options have been used successfully in such situations to attract employees willing to bet their financial futures on the success of the business. The model has been success and has resulted in employees who become very wealthy.
ESO offer employees the chance to leverage the growth of a company and the rise of its stock prices. When the price rises, employees can exercise their options and enjoy the immediate income because the prices of options are usually lower than the market price. They can also sell the shares and pocket the spread pursuant to the terms and conditions of their plan.
Taxation can be another reason employees opt for options. By converting part or all of a compensation package into capital gains, employees can enjoy better taxation. This is especially important for highly paid executives and high-level employees of large corporations.
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