Stock Options for Employees

Wednesday August 25, 2021

Stock Options for Employees

Stock exchanges have a long history within America. The first was the Philadelphia Stock Exchange, originally the Board of Brokers of Philadelphia, founded in 1790 and was followed by the New York Stock Exchange two years later. For nearly as long as the United States has been a country, they have had brokers buying and selling stocks. 

 

Since the latter half of the 20th century, however, the idea of stock options for employees has been popular as an incentive tool for employees to have a vested interest in the company’s success. For both publicly traded and private companies, offering employees the opportunity to be awarded or purchase shares is a powerful incentive. This practice has continued into the modern-day, as grantees (the employee or executive of a company) can receive the option to buy stock in the company for a fixed price in a finite time. This process also includes a vesting period, which is a period of time that a grantee will need to wait before they can exercise their stock options.

 

There are two main types of stock options, Incentive stock options (ISOs) and Non-qualified stock options (NSOs). The difference between these types is that the former is usually offered to top talent and executives while being treated as capital gains when taxed, while the latter is granted to employees of all levels and considered income when taxed after being exercised. For example, as an incentive to continue excellent performance, a company can give an employee or executive the option to buy 500 shares in the company at $5. As the name indicates, this is an option that an employee is granted the right to do, but it is not an obligation. If the employee buys the stock at $5 over the period designated by the company, the employee will then have the option to sell the share after the vesting period has passed. 

 

Most plans for employee stock options allow a percentage of stock to be sold each year. In our example, if the company allows for 20% of the stock to be vested each year, after one year, an employee will have the ability to sell the 100 shares of their stock options, and so on for each year as the stocks continue in the vesting process. The advantage for employees granted the right to exercise stock options in the company that they are working for is that they will, in most cases, receive that stock at or lower than the market price. The purpose of this is to make an employee feel like the company’s success is tied to their success as well. If they can work to further the company’s goals and raise the price of the company’s stock on the stock market, the employee can sell their stock options and make a profit. 

 

Continuing our example, if the employee has $2500 in shares in the company and the market price increases, they will make the difference. So, if the company reaches $8 per share by the time the employees’ stock is fully vested, they can sell it for $4000, for a $1500 profit. 

 

The typical scenarios for this type of stock option are in start-up companies or as incentives to bring the best talent to a larger company. For the company, the incentive does not come from the operating budget but helps to involve employees in the company’s success. The success of the company is a success for all. 

 

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