Employee Stock Options (ESOs) are a great way to incentivize employees as they directly connect one’s performance to their compensation through company equity. In essence, the harder you work, the more profitable the company will be, and the higher your overall salary will be.
Employee Stock Options provide an employee the ability (but not the obligation) to purchase company stock at a discounted price. Even the humblest of employees can earn millions of dollars. Unfortunately, employees can be left with worthless options, end up owing loads on taxes, or simply lose a lot of money.
Should you accept ESOs?
Before agreeing to a compensation package that includes employee stock options in lieu of a higher salary, one must be supremely confident in a few things:
Before agreeing to a compensation package that includes employee stock options in lieu of a higher salary, one must be supremely confident in a few things:
- The company will survive an IPO
- The company will succeed
- You won’t be laid off
- You will have a way of exercising your ESOs
- Having a large number of ESOs or company stock aligns with your risk profile
- You will stay with the company for the long term
Simply put, ESOs aren’t all that they are hyped up to be. That’s not to say that one should avoid them at all costs, but one should fully understand the risk/reward ratio and accept that, by accepting ESOs, you are quite literally investing in that company. Things can quickly go wrong – for example, many start-ups issue ESOs to early employees but then never make it to an IPO. Or, they make it through the IPO, and the share value collapses.
As we’ve recently seen in early 2023, tech layoffs are a real possibility, leaving employees jobless and without the much-anticipated compensation from their ESOs. Finally, when you exercise your ESOs, you need funds to actually purchase the stock.
Exercising ESOs
ESOs are issued with a Fair Market Value, also known as a strike price, and an expiration date. The profit one makes is the difference between the Fair Market Value and the Exercise Price, or whatever the price of the stock is when you decide to sell your shares. Let’s look at an example.
Company XYZ issues employee Shane 5,000 ESOs with a Fair Market Value of $10. The share price balloons to $30, allowing Shane to purchase the stock at a heavily discounted price. If he can manage to buy at $10 and sell at $30, he stands to make $20 a share (minus fees and tax). But Shane still needs to pay $50,000 to purchase them. So, how can he do that?
There are a few different options available when exercising ESOs.
- Exercise & Sell
In this case, Shane won’t need to cough up 50k to purchase the shares. The options will essentially ‘convert’ to shares and be sold right away on the open market. An exercise & sell strategy is highly recommended as it eliminates market risk immediately – but beware of the high tax tag. - Exercise to Cover
Here, Shane wants to buy and hold as many shares as possible, but he doesn’t have $50,000 lying around. He exercises and sells the amount necessary to cover the purchase of the remaining shares. - Exercise & Hold
Shane wants all 5,000 shares, so he needs the funds to do so. Some agencies will fund the exercise – for a price. Otherwise, he will need to raise the funds himself.
Concentration Risk
Options two and three lead me to my next point. Unless one already has an extensive, diversified portfolio where the inclusion of 5,000 shares of a single stock won’t significantly distort the asset allocation correlated to your risk profile, it probably doesn’t make sense to hold a large number of shares of one stock.
The share value of a stock can dip below the original Fair Market Value and never return. You’re looking at an inevitable loss if the stock doesn’t pay dividends. Also, many start-up companies are growth stocks, meaning they don’t pay dividends. Instead, they reinvest all profits into the company. By owning a large portion of shares of the company, your sole hope is that the company grows so you can sell for a higher price later. All too often, that simply doesn’t happen. In the worst case scenario of a company failing, you’ve lost 100% of your original principal.
ESO Vesting Schedules
It gets more complicated than just taking a slew of ESOs and waiting until they become profitable. Most ESOs are issued under a vesting schedule, the details of which are in your employee contract. A typical vesting schedule looks like this:
End of Year 1: Shane receives 1,000 of his promised ESOs. Depending on the type of ESO, he can exercise right away or must wait for a year (more on that later).
End of Year 2: Shane receives another 1,000 ESOs.
Years 3-5: Rinse and repeat
After six years, Shane has finally received all of his employee stock options. Hopefully, it was worth the wait. By the way, if you ever feel the grass is greener on the other side and jump ship to a competitor, your former company may have the right to take back any profits you made through their ESO compensation plan.
Two Types of Employee Stock Options
Yes, things get more complicated. There are two types of employee stock options with different methods of taxation and different exercise periods.
ESO #1: Incentive Stock Options (ISOs)
ISOs are usually issued to executives and provide grantees to not only purchase company stock at a discount but also pay lower taxes on any profits – with certain conditions.
ISOs have a two-year vesting period and a one-year holding period. You must wait three years before exercising them to receive the tax break. Upon meeting these conditions, you qualify for the substantially lower long-term capital gains tax, which, at the time of writing, consists of three brackets depending on your income: 0%, 15%, and 20%.
Two elements (and two taxable events) are associated with incentive stock options.
- The Bargain Element
This is the difference between the Fair Market Value (strike price) and the market price at exercise. This difference is subject to ordinary income tax if not all conditions are met. However, if all requirements are met, no tax is owed on it at all. - The Capital Gain
This is the difference between the market price at exercise and the market price at the time of sale. If you sell at least two years after the grant date and observe the one-year holding period, you owe only the long-term capital gains tax.
So, there is a substantial tax incentive to adhere to the conditional elements of ISOs – but should you? Holding onto stock options and stocks for years exposes you to considerable market risk. It may be possible to exercise early and sell off the stock at a higher tax rate – but you’ll at least lock in a profit.
ESO #2: Non-Qualified Stock Options (NQSOs)
Non-qualified, meaning they do not generally qualify for special tax status. The most significant difference is that they don’t require a holding period. Once the options vest, you can exercise right away, thus significantly reducing the risk of holding on to the shares for a year.
Just like ISOs, NQSOs also have two elements. But unlike ISOs, there is no way to avoid the bargain tax. No matter what, you are stuck paying regular income tax on the difference between the Fair Market Value and the strike price.
If you sell your shares immediately or less than one year upon exercising, you will owe short-term capital gains tax on the difference between the strike price and the market price when you sell the shares. Unfortunately, at the time of writing, the short-term capital gains tax is the same as regular income tax.
Paying the lower long-term capital gains tax is possible if you hold onto your shares for more than a year. But as I’ve already mentioned, you’re putting yourself at significant risk by holding to so many shares.
ESO Alternatives
ESOs have gotten a (probably deservedly) bad rap over the years. Several high-profile cases involving ESOs, such as Enron and WeWork, have driven employers to develop safer alternatives.
Restricted Stock Units (RSUs)
RSUs are very straightforward – your company issues you a round of RSUs, and after vesting or meeting a performance requirement, they award you actual shares, which you can then hold or sell. There is no risk of losing money because you never have to put your own funds on the line. They are also less risky because the chance is slight that the share price will drop to zero – and if that happens, you probably have bigger problems on your plate. But even if the share price plunges 50%, you’re still guaranteed at least something. With ESOs, it is possible that the share price drops below the strike price and never rises above it again, rendering them useless. With RSUs, this simply isn’t a possibility.
Stock Appreciation Rights (SARs)
This clever equity benefit works similarly to RSUs, but only provides a profit if the share price increases. Rather than getting issued an actual share, you receive a bonus equal to the growth of the share price minus the Fair Market Value of the SAR at the grant date.
For example: Shane receives 100 SARs with a Fair Market Value of $10. Upon vesting, the current share price is $12. He immediately exercises for a $200 bonus.
Because they are dependent on growth and have a Fair Market Value, SARs are riskier than RSUs. The stock price may indeed drop below the Fair Market Value and never go back up or go back up only after the SARs have expired. Also, SARs are not in any way tax-advantaged. Any proceeds earned by them are taxed as regular income.
Phantom Stock
Phantom Stock is awarded in the form of a cash bonus equal to the current value of the stock or the growth of the stock from a specific date (similar to SARs – the difference being that phantom stock bonuses are paid on a particular date rather than being exercised by a grantee when they so desire).
Full-value phantom stock is naturally less risky than its SARs-style cousin because, like RSUs, they aren’t likely to lose their total value. Appreciation-only phantom stock bears the risk of a 100% loss, just like Stock Appreciation Rights. In any case, the proceeds are taxed as ordinary income.
Employee Stock Purchase Plan (ESPPs)
ESPPs are a prevalent method to allow employees to purchase stock at a discounted rate. A company announces that it will begin deducting money from employee salaries of those who opted in. On a specific day or over a particular period, shares are purchased in the name of said employees. Unfortunately, a significant sum of money must be put on the line to acquire shares. Unless shares are immediately sold for a profit, there is a high risk of losing a large portion of the principal.
In Conclusion
Employee Stock Options and their alternatives are a great way to tie worker performance to compensation in a tax-advantaged manner. Indeed, many have earned vast sums of money and left their companies wealthy. Unfortunately, they pose a significant risk through market volatility, concentration risk, and a slew of conditions that must be met even to receive them. They neither can nor should replace a well-managed, diversified investment portfolio with a proper asset allocation according to a carefully calculated risk profile.
If you are currently an ESO grantee or are being offered ESOs as a form of equity benefit, I strongly advise you to reach out for further guidance. This article has only touched upon the basics, and each ESO plan is unique to your specific financial situation and goals.
