Through an employee stock option plan (ESOP), it is possible for you to add tens of thousands of dollars in wealth to your bottom line over the long term. With an employee stock option plan, you can purchase shares of company stock for prices beneath their market value. ESOPs, however, do expose both employee shareholders and non-employee investors to significant financial risks. All corporate shareholders should become familiar with how ESOPs are structured, before making financial decisions.
Employee Stock Option Plans – Strike Price
Employee stock options allow you to purchase shares of company stock at a set strike price. You will exercise employee stock options when the stock market price for company shares exceeds your strike price. For example, you may be granted employee stock options that carry rights to purchase shares in Corporation X for $50. You would consider exercising your stock options, if Corporation X were to trade above $50 per share in the stock market.
Employee Stock Option Plans – Corporate Strategy
Corporations grant employee stock options in an attempt to align outside shareholder interests alongside those of insider employees. Employee stock options gain in value as company stock prices appreciate. Corporate managers are therefore motivated to take actions that drive company share prices higher–to improve their respective level of compensation through employee stock options.
Employee Stock Option Plans – Taxes
ESOPs present complicated tax ramifications–because they combine employee compensation alongside an investment component. Tax issues are triggered when you exercise employee stock options, and not when the options are actually granted.
When you exercise options, the difference between your strike price and market value for company stock may be treated as employee compensation and subject to ordinary income taxes. For example, you may exercise stock options to buy Corporation X shares for $50, while it trades for $75 in the stock market. You could then owe taxes on $25 worth of ordinary income. In three years, you may be able to sell Corporation X shares for $120. At that point, you would be subject to capital gains taxes on the $45 in profits ($120 – $75 = $45).
Employee Stock Option Plans – Investment Strategy
Employee stock option plans expose existing shareholders to dilution, because the corporation may be forced to issue new shares of stock when employees exercise options. Higher amounts of outstanding common shares translate into lower ownership percentages for each individual share. To protect the interests of non-employee shareholders, a corporation can spend cash on stock buy backs to neutralize potential dilution from employee stock options. As a prospective investor, you can review a corporation’s balance sheet and statement of cash flows to review its amount of outstanding common stock and stock buy back policy.
As an employee, employee stock options may leave your finances too concentrated within one company. If your employer were to fail, you would be out of a job–at the same time that your company stock options and shares become worthless. To manage financial risks, you may consider immediately selling company stock after you exercise options. From there, you can direct the cash proceeds into a diversified stock market portfolio.
Buying Stocks – Employee Stock Option Plans (ESOPs), Sources:
IRS: Stock Options
IRS: Capital Gains and Losses
USA Today: Beware of taxes with your stock options