What is an employee stock option? How does it work?
Thinking of employee stock options? How do employers offer this type of stock to their employees? If you are wondering about this stock option, you might have been offered by any startup. Or perhaps, you are offering this type of stock to your employees?
Generally, startups don’t have enough cash, so they offer stock options as an extra incentive to their employees. In order to retain and attract workers towards the business, startups need to do something. So, they started offering the employee stock options to their workers.
After all, employees come on the board to earn a good amount of salary. If they don’t get it enough, they will look for other options. In order to offer a certain amount of salary, employers have started giving this option as part of a compensation package. So, if you are in this situation, make sure that you know how they work. You can’t say ‘yes’ to every compensation package; you should first learn about it. Let’s start with the definition of ESOs.
What Are Employee Stock Options (ESOs)?
Employee stock option plans are top-rated options of motivating, attracting, and also retaining the employees. This option works wonderfully when the company is unable to offer high salaries. So, if your company doesn’t have enough capital, you can adapt this method. This plan gives the company the flexibility to award stock options to consultants, employees, officers, advisors, and directors and also allows them to buy stock in the company when they exercise the option.
To be more precise, employee stock options are a kind of equity compensation offered by the startups to their executives and employees. Instead of issuing them the company’s shares directly, the company gives the derivative options on the stock.
Well, employees get these options in the form of regular calls, so they reserve the right to purchase the company’s stock at a specified price for a finite period of time. But always remember to check all the agreements in the employee stock options plans. All the terms of ESOs will be fully spelled out for an employee in an employee stock options agreement.
Do you know that thousands of people have enjoyed the benefits through employee stock options? Facebook, Indeed has made several employees of their company into millionaires from the stock options. The spectacular success of Silicon Valley companies and the resulting economic riches of the employees who hold the stock options have made this compensation package a powerful motivational tool for employees to work for the company’s long-term success.
Do you also become a part of this plan? But before becoming a part of this plan, you should know, ‘how does it work?’ In this way, you will get a certain idea about whether you should indulge yourself in this program or not!
How Does a Stock Option Work?
To help you understand how employee stock options work, let’s walk through a simple example. The below-shared example will show you how stock options are granted and exercised:
Let’s say; you got a new job at a novice startup.
And as it is predicted that new startups don’t have enough money to offer their employees. So, they always look for other compensation packages in order to attract them. While offering the job to you, they also give these stock options as part of your compensation package.
Let’s suppose; you have received the stock options worth 20,000 shares of the company’s stock at 25 cents per share. To make the terms clear between two parties, you and the company will need to sign a contract that outlines the terms of the stock options; this might be included in the employment contract.
When you sign the contract, you will get the grant date, which means on that specific day, your stock options will begin to vest. It means that these stocks can be exercised on that day- that is, to buy. Well, when you join a company, unfortunately, you will not receive all of your options right. Generally, the stock options vest gradually over a period; that is why, this period is known as the vesting period.
Let’s suppose; you choose to have a four-year vesting period with a one-year cliff. In that case, you will take four years before you have the right to exercise all 20,000 stock options. However, there is a twist. As stated above, the stock options vest gradually over a certain period of time. So, you will get the chance to access some of your stock options before those four years are up.
In short, one quarter (5,000) of your options will likely vest each year throughout the four-year vesting period. So by year two of your employment, for instance, you’ll have the right to exercise 10,000 options. This is how the stock options work in a company.
However, if you decide to leave the company or get fired before the end of the first year, you will not get the chance to access any of the options. So, as soon as your options get vested, in short, become exercisable, then you can buy the stock at 25 cents per share, even if the share value has gone up dramatically. After four years, all 20,000 of his option shares options are vested, if he has continued to work for the company.
And if the company becomes successful and goes public, then the stocks can be traded publicly. When it gets public, any employee can buy it and increase the share capital over the company. Let’s suppose, it is traded at $20 per share. So, if you want to grow your share capital at that time, you can exercise your right and can buy 40,000 shares for $10,000 (40,000 x 25 cents). In order to gain a nice profit, you can sell all your 40,000 shares for $800,000 (40,000 x the $20 per share publicly traded price), making a profit of $790,000. Don’t you think it is a good option for the employees to become a millionaire?
Why Do Companies Issue Stock Options?
Several people ask the reasons from the employers for the issuing of employee stock options to the workers. If you are one of them, below shared are some reasons for it, that you should know-
- To attract and retain talented employees.
- To attract great employees so that small companies can compete with larger companies.
- To motivate employees to bring more dedication to the work premises.
- To prepare a cost-effective employee benefit plan, in lieu of additional cash compensation.
Critical Issues in Employee Stock Options
Before adopting the employee stock options plan, a company needs to address several key issues. Here are some of the important considerations that need to be fulfilled in order to give maximum flexibility-
The total number of shares:
The first and foremost important considerations that need to be fulfilled is to issue the maximum number of shares under the stock option plans. Well, the total number of shares is generally decided by the board of the directors, ranging from 5% to 20% of the company’s outstanding stock.
The number of options granted to an employee:
Well, there is no hard and fast rule to calculate how many options a company can grant to a prospective employee. Even though companies can set up the internal guidelines as per the job position within the company, still it’s all negotiable. In general, the total number of granted options is not important.
But what number represents as a percentage of the fully diluted number of shares outstanding is important. For instance,- John has been awarded 100,000 options as a compensation strategy, but 100 million shares are outstanding. It means that he will get only 1% of the company’s shares. However, he is awarded 100,000 options, and only 1 million shares are outstanding, then it represents 10% of the company.
Shareholder approval:
Shareholders reserve the right to approve the employee stock options plan in the company. In fact, they also have the right for securities law reasons and to cement the ability to offer tax-advantaged incentive stock options.
Right to terminate employment:
In the option agreement, it should be clearly stated that the grant of stock options doesn’t guarantee any employee to have a continued relationship with the company. Whenever an employee leaves the company or gets fired, your shares will stop vesting immediately, and you can only buy shares that have vested as of that date.
Right of first refusal:
The stock option agreement can also offer the right to the shareholders to refuse the first proposal or transfers of the underlying shares. In this way, the employers can keep the share ownership of the company to a limited group of shareholders.
Vesting:
In simple words, vesting means to earn the employee stock options over a certain period of time. Usually, companies do this in order to motivate the employees to stay and contribute to the company’s success over many years. This is why companies offer the vesting period to the employee to work for the company before the options vest. For example- you get the chance to acquire 20,000 shares with 15% vested after the first full year of employment, and then monthly vesting for the remaining shares over a 36-month vesting period.
Bottom Line
By now, you would have got a better idea about the employee stock options and how it works. Nowadays, stock options are becoming the most common method for startups to attract and retain their employees. The stock option plans are not as straightforward as a paycheck, but they have a lot more potential than the paycheck. In order to get the chance to assess the shares of the companies, employees need to sign the option agreement with the company. This option agreement will let you know all the guidelines set by the employers for the company’s success.
