Imagine a new hire at a startup who receives a modest salary along with some employee stock options. The new employee hopes for a big payoff in the future. However, while some dreams come true, a lot rests on the type of stock options offered, not to mention whether the company thrives or even survives.

What are employee stock options?

An employee stock option (ESO) is a form of equity compensation a company offers to some or all workers. As the word “option” indicates, the employee is given the option to buy shares of the company’s stock at a specific price within a given period of time. That price could be the market price at the time the option is awarded or some other specified price. Buying stock options is usually called “exercising” the option to buy.

The option becomes valuable if the future stock price is higher than the price stipulated in the option. However, the option may not be worth anything if the company doesn’t do well and the share price doesn’t rise. 

Stock options allow employees to participate in the company's growth while also encouraging their productivity and longevity. Startup companies often issue ESOs as part of an employee’s compensation because it allows them to conserve cash needed for growth and to reward early employees if the company goes public. 

Employees who receive options are incentivized to stay until the options vest, or become theirs. Any unvested shares are usually forfeited when an employee leaves the company. Options also usually expire some time after an employee leaves the company.

How do stock options work?

There are two key elements of stock options: grants and vesting.

Grants are how a company awards stock options as detailed in an ESO agreement. The agreement will spell out the following conditions:

• The type or types of stock options available.
• The number of shares to be granted.

Also spelled out in the agreement are the vesting terms, or the time frame in which an employee has the right to exercise the stock options. Employees must often pass a so-called vesting cliff—a certain amount of time set by the company—before options can be exercised.

The ESO agreement will also indicate that when an employee leaves a company, any unvested options go back into the company’s options pool. Some companies allow for early exercise options that may offer tax advantages depending on the situation.

The vesting schedule is also contained in the ESO agreement, while the following terms define the process:

• Option term or expiration date.

  The period when the employee can hold the option before it expires.

• Exercise.

  This is when the employee chooses to take advantage of, or exercise, an option and purchases shares.

• Exercise price, strike price, or grant price.

  This is the cost associated with buying shares, usually based on the stock's fair market value at the time of the grant.

• Spread.

  The difference between the exercise price and the stock's market value at the time of exercise.

What are the two types of employee stock options?

Employee stock options come in the form of incentive stock options (ISOs) and nonqualified stock options, sometimes known as nonstatutory stock options (NSOs). 

Incentive stock options (ISOs)

Incentive stock options (ISOs) are usually only granted to full-time employees or top management. These options are often valid for up to 10 years and usually remain valid for three months after an employee departs.

Profits on ISOs are treated as long-term capital gains, meaning they may be taxed at a lower rate than on ordinary income. An employee must hold shares for at least one year from the exercise date and two years from the grant date to receive this tax treatment. No tax is due at the time the options are exercised—only when the stock is sold. However, if exercising options triggers the alternative minimum tax, a quarterly estimated tax payment may be necessary. 

Because ISOs qualify for certain tax advantages, there is an annual limit imposed on the value of ISOs an employee can exercise in a year: $100,000. This is sometimes referred to as the $100K Rule and is meant to prevent overuse of the tax benefit. Any amount exercised above $100,000 in a single year is taxed as an NSO at the person’s ordinary income rate. To deal with the $100K Rule, option grants that exceed the $100,000 limit can be divided into ISO and NSO segments, commonly referred to as an ISO/NSO split.

Non-qualified stock options (NSOs)

Non-qualified stock options (NSOs) can be granted to employees at any level, including board members and consultants. NSO profits are considered ordinary income and taxed accordingly. But just like ISOs, no tax is required when the options are granted. But unlike ISOs, they’re taxed upon exercise. They’re also taxed when sold. 

Restricted stock as an alternative to ESOs

Rather than receiving ESOs that must be purchased, certain employees may be awarded restricted stock as compensation. These shares are also sometimes known as letter stock or section 1244 stock after the IRS rules that govern restricted shares.

The word “restricted” refers to the limitations placed on the stock that prevents its immediate sale or transfer of ownership to the recipient. Restricted stock can only be sold after a graduated vesting schedule takes place, usually over four or five years. The idea is to incentivize workers to stay with an employer.

While some employees receive restricted stock in the form of restricted stock awards, another common way restricted stock is issued is in the form of restricted stock units (RSUs). These are favored by many startups. They are like a promise of a future award of restricted stock, postponing the time when the employee must recognize the income for tax purposes. 

RSUs are similar to employee stock options in that both must adhere to a vesting schedule. Yet RSUs are earned rather than purchased and are treated by the IRS as a bonus, which means the tax rate on RSUs may be higher than that on regular salary. If an employee decides to leave a company before restricted shares reach a vesting threshold, they will lose the restricted stock. However, shares vested before leaving can be retained. 

Unlike stock options, RSUs are taxable as ordinary income in the year they vest. Some companies will handle taxes on RSUs and withhold them from an employee's paycheck. Also, publicly traded companies might offer to sell a portion of the employee’s shares to cover the tax liability.

A holder of restricted stock can opt to report the fair market value of their shares as ordinary income on the date the shares are granted rather than when they vest in the future. This is called an 83(b) election under IRS rules and must be filed within 30 days of the grant. This is essentially pre-paying taxes at a lower valuation, assuming the stock’s price increases in the future. However, this approach can be risky if the shares decrease in value—in that case the holder would have overpaid the tax. Also, if an employee decides to leave before restricted shares are fully vested, they have paid taxes on stock they will never receive. The IRS does not allow for a claim of overpayment of tax, in such cases.

The bottom line

Employee stock options and restricted stock represent a form of compensation designed to incentivize and retain workers. Both can be financially rewarding because an employee’s compensation can grow as a company succeeds and the shares increase in value. Option grants are especially popular among startups to lure workers in lieu of higher salaries, allowing the startup to conserve scarce cash needed for growth.

Stock options and restricted shares are subject to tax treatment that can vary—in some cases, profits are treated as capital gains, and the employee pays a lower rate than they do on regular income. However, options only become valuable only when the company succeeds, the share price rises and the worker stays with the employer so that they can buy the shares and then sell them for a profit. The value of restricted shares, on the other hand, rises or falls with the company’s stock price. In both cases, if the employee leaves before the options or restricted shares vest, the award may be forfeited.