What are Stock Options and How Do They Work?

To incentivize employees and drive a stronger alignment of interests between the company and employees, employers offer employees stock options to buy shares of the company at a specified price based on performance and other targets.

On meeting these targets, employees can have these shares vest and exercise these options. 

Commonly seen in high-demand tech and development roles, these options can be a significant part of the total compensation once receives and a useful tool companies rely on to retain top talent.

The most common types of employee stock options are as follows:

1. Employee Stock Purchase Plans (ESPPs)

Under ESPPs, employees are able to procure shares of the company at a discount to the market price.

The terms of the ESPP often determine the number of shares and the extent of the discount offered to employees to participate in the ESPP.

Usually, employee stock purchase plans are part of secondary offerings brought to the marketplace and employees get a preference in the equity raise process. 

2. Employee Stock Option Scheme (ESOS)

These are commonly used instruments to promote employee ownership and retain talent within an organization.

Under this scheme, employees have the right to buy company stock, but not an obligation to do so.

These options vest on meeting certain performance goals or staying with the organization for a specified period.

When these options vest, the employee can acquire the shares by exercising the options and paying the agreed-upon exercise price.

3. Restricted Stock Units (RSUs)

RSUs represent shares that will vest on a predetermined date when certain conditions are met or a specified event occurs.

When the terms of an RSU are fulfilled, the employee becomes a shareholder as an RSU is a right rather than an option.

4. Stock Appreciation Rights (SARs)

While SARs aren’t employee stock options, companies use them in a similar manner by rewarding employees with a cash payment for any appreciation that occurs in the share price during a specified period of time.

However, the way SARs are structured, employees participate in the upside and don’t have clawbacks in case the share price dips.

Did You Know?

Louis Kelso, a San Francisco lawyer created ESOPs for the first time at Peninsula Papers Inc. in 1956

How do Employee Stock Options Work?

Employee stock options are well-defined contracts where depending on their structure will either create a right (but not an obligation) to buy shares of the company (ESOS), confer the rights and transfer ownership to the employee upon fulfilling certain conditions or when a certain predetermined event takes place (RSUs), or provide a cash payment equivalent to a stock appreciation in a given period of time (SARs).

Despite the different mechanics of each particular stock option plan, the underlying theme remains: incentivizing employees to perform better and minimizing turnover.

Most plans have a vesting period and a schedule tied to the vesting period that outlines the period or events which will lead to an unlock of these options.

While each company is free to draft its own plan and benefits package, the most common vesting schedule involves assigning a certain number of options on a period basis, yearly for example, thereby providing an incentive for employees to stay with the company for a longer period.

When these options have been vested, the employee can claim ownership and pay the agreed price to own these shares.

It is common for a tax bill to accrue as most options are priced at a discount to the Fair Market Value and incur capital gains.

How Much Are Your Options Worth?

Each company has a unique employee stock compensation plan and depending on the maturity of the company, the stage when the stock options were granted and the funding round of the company, the value of stock options can vary vastly.

Further, private market investments are inherently more opaque than public markets with lesser transparency into the deal size, valuation and terms of investment. 

The most common inputs for pricing employee stock prices and calculating the worth of these options are as follows:

  • Strike Price: This represents the grant price or price at which the options can be exercised.
  • Current Share Price: This is often called the Fair Market Value per common share. For a publicly listed enterprise, it’s simple to obtain the last traded price, however for a private enterprise, third-party valuation experts can determine a range based on the funding rounds, market conditions and comparables in the industry.
  • Vested Shares and Vesting Period: Using the vesting shares and the vesting period, we can obtain the number of shares that will be available in the future period. This is useful to determine the value of the total shares that will vest if the employee stays for an extended period.

By using these inputs, a broad range can be established for the value of the employee stock options.

Group of employees at startup

How to Exercise Your Options

Options can be exercised once vested and depending on how the employee stock option is structured, the employee will have one of the following methods or a combination of the below to exercise their options: 

  • Pay Cash (Exercise and Hold): Under this method, the employee pays cash for the exercise or grant price to own the shares outright. At this point, if the company is privately listed, the employee is waiting until a liquidation event and speculates on the value of the company going up. However, there is less ambiguity in the case of public companies as the trading price is known. 
  • Cashless (Exercise and Sell to Cover): Under this alternative, the employee disposes of enough options to cover associated costs of exercising the options and is left with the remaining shares which can be disposed of right away or can be held for the future. 
  • Cashless (Exercise and Sell): When a company offers a secondary issue, the employees are given a chance to participate by selling their options and receiving net proceeds from their vested shares.

It is important to be mindful of tax consequences while exercising vested options.

There can be a substantial tax liability depending on the exercise price and fair market value of the shares.  

Key Considerations When Evaluating Employee Stock Options

  • Vesting Period: Granted employee stock options take a specified period to “unlock”, only after which the employee can exercise these vested options.
  • Tax Treatment: While exercising vested options, employees have to keep in mind the tax implications of such actions and set aside funds to meet this obligation. 
  • Hedging: Oftentimes, when a public listed company has Restricted Stock Units vesting, it leads to a surge in supply and market participants sell their shares to minimize market risk from oncoming RSU supply.

Frequently Asked Questions

  • What is meant by employee stock options?
  • How do employee stock options affect the stock price?

Sid Mohapatra is an energy trader based out of Toronto working in power and natural gas trading. Prior to working in commodities, Sid worked at a top Canadian bank’s fixed income and derivatives business. He possesses strong fundamentals in asset allocation, global macro thematic investing and physical commodities.

As a graduate of McMaster University, Sid specialized in Finance and has taught numerous sessions on Investing, Financial Securities and Trading courses. He led and managed the Horizon’s Trading Center at McMaster University.

Sid’s unique experience brings a breadth of institutional knowledge to the retail investing universe. He covers equity derivatives, structured credit instruments and tax harvesting techniques to help Canadians make better financial decisions in the ever-changing landscape of financial markets and investing.