Whether you’re running a start-up and focusing on how to attract the best talent through offering a stock plan, or you’re on the employee side of things, the following are some of the core elements of an employee stock option plan to be aware of.
The Basics of An Employee Stock Option Plan
An employee stock option is one type of equity compensation. The equity compensation is granted by a company to its employees and executives. With an employee stock option, rather than granting shares of stocks directly, the company gives directive options instead.
These options come as call options.
Then, the employee has the right to buy their employer’s stock at a specified price for a certain period of time.
The specifics of an employee stock option will be determined in an agreement that the employee and employer sign.
A call option is a financial contract giving the option buyer or holder the right to buy a stock, bond, commodity, or asset at a particular price within a certain time period. They aren’t obligated to buy it, however.
If you’re the call buyer or holder, you profit when there’s an increase in the underlying asset.
By contrast, a put option gives you as a holder the right to sell your underlying asset at a specific price before or on expiration.
Unlike exchange-traded options, an ESO is usually issued by the company and can’t be sold.
In the example of an ESO, as far as the call option, when the stock price goes above the option exercise price, then you can exercise your call options. You then get the company stock at a discount, and you can sell it immediately in the open market and take a profit, or you can hold it over time.
There’s also an ESPP, which stands for employee stock purchase plan. An ESPP lets you use your after-tax earnings to purchase stock in the company you work for, typically at a discounted price. ESPPs are common in publicly held companies.
Along with ESOs and ESPPs, there are restricted stock grants, which give employees the chance to acquire or receive shares after certain criteria are met, like working at the company for a certain number of years.
There’s another type of equity compensation called Stock Appreciation Rights or SARs which provide the right to increase the value of a certain number of shares, and that increase in value is payable as company stock or cash.
How Does an ESPP Work?
Back to ESPPs specifically—how do they work?
This is an employer benefit that some publicly traded companies offer. Most of these programs allow employees to enroll during an offering period, which is usually 12 months. When an employee participates, they can choose to have part of their pay, up to 15%, set aside by the company.
Then, every six months, the company will use those funds to buy shares of the company stock at a price below market value.
Your employer stock is bought with money you’ve already paid taxes on. Then, your taxes are due only when you sell the ESPP.
Should You Participate?
If you use an ESPP correctly, it can be a good investment. You’re buying the stock at a discount, which is already good from the perspective of accumulating wealth. Of course, it’s also an investment that comes with risks.
As is the case with any other stock, the value of your ESPP shares can go down or can go away.
Some of the advantages of ESPPs include the discount, of course. Then, many plans will have what’s called a look-back provision that will let them use the lower company share price of the purchase date or offering date. ESPPs from employers’ perspective can serve as a motivator to employees to help the company succeed financially because they benefit from it.
ESPPs are simple for companies to administer and maintain overall, and you can sell the stock before you retire if you’re an employee, so your portfolio isn’t too heavily weighted.
Should You Participate?
If you’re debating whether or not to participate in an available ESPP, you should ideally look at how it will fit into your larger financial plan. You shouldn’t depend on it entirely since it is risky, just as you would otherwise be unlikely to put all of your money into a single stock outside of your employer.
It’s a good idea to talk to a financial professional before you decide to participate in an ESPP.