Employee stock options (ESOs) offer employees the chance to purchase company stock at a potentially reduced price—which can result in a tremendous windfall. These options often impose certain limits on factors such as how much stock employees can purchase, when they can purchase it, and the (discounted) price they will pay.
Companies often use ESOs to encourage employees to stay with the company and to perform well (which, in turn, should help raise the stock price). ESOs are sometimes used in start-up companies to encourage employees to get the business off the ground and to reward them for their efforts.
As the name suggests, employees have the option to purchase stock—they are not required to do so. Whether or not employees choose to exercise these options will depend on a number of factors, including the limitations imposed by the ESO itself.
How ESOs Work
At its heart, an ESO enables employees to buy company stock today, but at a price from a date in the past. If the stock’s value has risen over time, employees who exercise ESOs will pay below market rates for each share. From there, employees can choose to hold the stock for the long term (hoping it appreciates further), sell it at a future date, or sell it immediately.
ESOs are intended to get employees to remain loyal to the company for a minimum period of time. To achieve this, they may employ several techniques.
The first is that ESOs are offered only to employees. When employees leave the company, their stock options are no longer valid.
Further, ESOs typically aren’t valid right away, thus requiring employees to stay with the company for a while to realize this benefit. If an ESO is issued on Jan. 1, 2020 (the Grant Date) employees may not be able to exercise these options before Jan. 1, 2021, for example.
The company also may spread out the number of shares available to employees, according to a certain schedule (known as a vesting schedule). So every year for a certain period of time, employees might gain the ability to buy 100 additional shares, for example. This can effectively require employees to stay on board for additional time to maximize the benefit of the ESO.
Potential ESO Challenges for Employees
ESOs are valuable only if the company stock price goes up. If the price stays the same or declines, the ESO offers no benefit to employees.
ESOs issued by start-up companies have value only if the business eventually goes public. If not, the options are worthless.
The same is true if employees hold their options too long, and they expire. (Remember that ESOs are valid only for a certain window of time. Once that window closes, employees cannot exercise the options.)
In addition, to limit their liability, employers typically impose restrictions on ESOs, often limiting the number of shares employees can purchase, or the total dollar amount they can invest.
Perhaps the biggest challenge for employees is that ESOs require them to invest their own money, taking cash out of their pockets. Employees can avoid paying out of pocket by selling some of the shares they purchase to pay expenses and fees. They also can sell all of their shares immediately, in which case no cash leaves their accounts. But doing so lessens or eliminates the employee’s connection to the employer through the company stock.