'Employee Stock Option (ESO)' is explained in detail and with examples in the Investments edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Employee stock options are call options that are awarded privately rather than publicly. They turn out to be the most common form of equity compensation provided to employees of a business. Companies give out these options to their employees to provide them with an incentive to build up the market value of the company. These options may not be sold on the open markets.
An ESO provides the receiving employees with the right but not obligation to buy a preset quantity of shares of the company. The contract specifies a time frame within which these must be acquired before they expire worthless. The price they employees can buy them at is the current price which becomes the strike price. These time limits for using them are generally ten years. Companies spell all of these terms out in the options agreement.
These options are only valuable to the employee if the price of the company stock increases during the exercise time-frame. This is because the employees then are able to purchase the discounted shares at the same time as they sell them for the greater price on the market. The difference between the two prices represents their profit.
If the share price of the company declines, they are unable to use them and will see them eventually expire worthless. This is why companies utilize employee stock options instead of large salaries to encourage their employees. This provides the companies with great incentive to build up the value of the company. Three principle types of ESO exist in the form of non statutory, incentive, and reload employee stock options.
Non statutory employee stock options are also called non-qualified. These prove to be the normal kinds of ESOs. In such a contract, employees are not permitted to use these options during the vesting period. This vesting timeframe ranges from one to three years. When they are sold, the employee makes the spread between current price and strike price times the number of shares he or she sells. These types of ESOs become taxable at the employee’s regular income tax level.
Graduated vesting in these options allows the employees to sell a percentage of the options such as maybe 10% in the first year. Each year another 10% would become available until the full 100% level is achieved by year ten. Incentive stock options are set up to lower taxes as much as possible. Employees can not exercise the option to buy the stock until after a year. They can not actually sell the stock until another year after buying it.
This type of option creates a risk that the stock price may decline over the year long holding time frame. The advantage to the employee is that these ISOs receive far better tax treatment. The tax rate defaults to the long term capital gains rate instead of the traditional full income tax rate. Upper level management are usually the ones who receive such tax advantageous ISOs from their companies.
The third type of employee stock options are called Reload ESOs. These begin their contract lives as non-statutory ESOs. The employees engage in their first exercise of the contract where they make money on the transaction. At this point, the employees who exercise are given a special reload of the employee stock option. In this process the company issues new options to the employee. The present market price at time of issue becomes the new strike price for the reloaded options. This way the employee is constantly re-incentivized to perform for the company.