What Are Employee Stock Options?
Employee stock options are often dubbed ESOs and they can be a useful tool for startups and other companies. Employers can use them to attract top executive talent when they’re unable to offer top salaries. The offer of employee stock options isn’t for top leadership alone. It sometimes makes sense for companies to open offers for stock options to all of their employees.
Publicly traded companies usually offer employee stock options. Privately held companies also sometimes offer their employees stock options and they have the ability to set up their own plans and pricing systems.
Under the right circumstances, employee stock options can be a lucrative venture for companies and their employees. The National Center for Employee Ownership reports that employees receive between 12% and 20% of their salaries at the time they choose to sell their stock options. When a company is doing well, employees can profit handsomely from their stock shares—sometimes in the ballpark of six or seven figures. This is how high-ranking executives can earn more than their base salaries.
From the company perspective, offering stock options helps them retain employees for longer periods and stock options are a good motivator for developing loyal employees.
Employers offer their stock options at a set price (known as the grant price, strike price, or exercise price) for a specified period of time, which is called the exercise period. All the details are outlined in the employee stock option plan.
The Vesting Process
Employee stock option plans will list the dates that employees can vest their shares and when they’re vested. While employees can purchase stock at the time of their employment, they don’t really own the shares until they’re vested. Vesting with employee stock options is quite similar to the process for vesting with employer–matched contributions in a 401(k) plan. Employees have the right to exercise their shares during the vesting period.
Employee stock option plans usually have expiration dates. If the employee doesn’t exercise their stock options, the stocks will have no value.
Employers can set up employee stock option plans so that they’re phased, or staggered. This means that a certain percentage of shares will be vested in increments. For example, the plan could state that 20% of the shares are vested after the first year, and another 20% are vested the second, third, fourth, and fifth years. After the fifth year, the shares would be fully vested. Consultants Watson Wyatt Worldwide did a survey that showed that most options are fully vested by the third or fourth year.
While the vesting period may span between one and five years, the exercise period may be as long as 10 years. The exercise period is the maximum time period that employees have to purchase or “exercise shares.” The plan may indicate a minimum period of time before employees can that employees have to meet before they can exercise their stock options.
About Stock Pricing and Selling
The strike price refers to the price per share that companies offer their employees during the exercise period. The strike price is commonly equal to the stock market’s value of shares at the time that stocks are granted, but that isn’t always the case. Depending on the type of option, the strike price may be lower or higher than the current stock market value.
It’s not uncommon for privately held companies to set their strike price based on the price of shares at the company’s last funding round.
Employee stock options are considered to be “in the money” when the stock’s market value is higher than the option price. Where the market value is less than the option price, the appropriate terms are “out of the money” or “under water.”
Companies may opt to reprice their options during times when the stock market is volatile. If the stock price drops, companies may allow their employees the option of exchanging their “out of the money” options for options that are “in the money.” For example, if a company offered shares at $100 and the stock market price dropped to $50, the company could cancel the higher priced shares and issue new options that employees could exercise at $50. This strategy is perfectly legal. It’s a practice that may upset outside investors because they don’t have any opportunities to take advantage of repricing opportunities when the value of shares drops.
Exercising Options for Employees
Employees have an annual opportunity to exercise their stock options. This means they can purchase them at them and then sell them. This is only a prudent option when the market price of the company’s stock is higher than the strike price.
Let’s look at a fictitious example of how this can work in the employee’s favor. If an employee purchased 100 shares of stock with a strike price of $100, their investment would be $10,000. Over the first year, if the stock price increased to $150 per share, the employee could then sell those shares on the open market at $15,000 which would yield them an attractive profit of $5,000.
This example provides a good example of why companies choose to offer employee stock options as an incentive for their employees. If an employee leaves the company for any reason, they lose their stock options. Stock options give employees a good reason to remain employed with the company. When the company prospers, employees that have purchased stock options stand to profit as well. This can be a good motivator for employees to work hard for the good of the company and it’s a great way to develop loyal employees.
Investing in stock options isn’t without its risks. The stock market is volatile. Certain circumstances have caused entire industries to fall out of favor, causing stock prices to drop suddenly. A large lawsuit is another reason that stocks may fall. Stock market prices may also fall during a bear market which is when a stock price decreases 20% or more for over two months.
Modern Cap Table Software Streamlines Workflows
With EquityEffect software, cap table management couldn’t be easier or more accurate to approve grants and stock options, warrants, and transfers of stocks. It’s the best solution for simplifying the process of getting the electronic signature of certificates and tracking vesting schedules, exercise periods, and expiration dates. EquityEffect has the ability to quickly generate auditor reports which give you confidence in compliance reporting.
EquityEffect provides the tools to manage all of your investment data from the highest fund level metrics to specific shareholder data. EquityEffect works diligently to solve the pain points that customers are talking about and improve the employee stock option processes that so greatly benefit companies and their employees.
