Are stock options good for employees?

Stock options and equity are two different ways of granting employees the right to own or buy shares of the company. Stock options give employees the option to buy a certain number of shares at a predetermined price within a specified period. Equity, on the other hand, gives employees actual shares of the company, either outright or subject to vesting conditions. Both stock options and equity can be part of an employee's compensation package, along with salary, bonuses, and benefits.

Desarie Hope, CPM, GBA

Senior Leader, Total Rewards

In my experience companies use a combination of stock options and equity. Equity being in the form of RSUs or DSUs. Employees also had the opportunity to purchase equity through an Employee Share Purchase Plan often times with a matching component from the employer. A good communication plan is needed as these forms of compensation can often times be complex for employees below the senior management level to understand.

One of the main benefits of stock options and equity is that they can motivate employees to work harder, smarter, and more creatively, as they have a direct stake in the company's performance and value. Stock options and equity can also help attract and retain high-quality employees, especially in competitive markets or industries where talent is scarce. Moreover, stock options and equity can reduce the company's cash outflow and tax liability, as they are not considered income until they are exercised or vested.

How do stock options work for employees?

Employee stock options give you the option to purchase your employer’s stock at a specific price. Employee stock options are generally granted or included in a worker’s compensation package, alongside a salary or hourly pay. An ESO stipulates that employees can purchase company stock at a certain price for a certain amount of time.

Note, though, that these are just the option to buy the stock. Shares are not being given directly to workers as compensation with an ESO. And they’re also different from exchange-traded stock options, in that they’re not necessarily available on the open market to any and all investors, like an index fund, ETF, or similar investment may be.

Employee stock options may allow workers to buy company stock at a discount, allowing them to effectively “buy in” to the company and increase the amount of equity they have. This may incentivize employees to work harder and more productively since the future value of their holdings will likely depend on how well the company ultimately performs. They’re more invested — literally and figuratively — in the company succeeding.

Again, stock options for employees are a form of alternative compensation — employees don’t have an obligation to use or exercise them. But if they do, how the employee stock option works ultimately comes down to a lot of specifics.

Broadly speaking, though, employees with ESO can decide whether or not to use them, which entails purchasing shares of their employer's company. If they choose to do so, they’ll need to refer to the specifics laid out in their contract. That’ll tell them how many stock options they’ll receive when those ESOs are granted, and when the ESOs vest, or become available to exercise or purchase. Again, this differs in a large way from how exchange-traded stock options work.

What are the typical employee stock options?

Many companies use employee stock options plans to retain, reward, and attract employees,[3] the objective being to give employees an incentive to behave in ways that will boost the company's stock price. The employee could exercise the option, pay the exercise price and would be issued with ordinary shares in the company. As a result, the employee would experience a direct financial benefit of the difference between the market and the exercise prices.

Stock options are also used as golden handcuffs if their value has increased drastically. An employee leaving the company would also effectively be leaving behind a large amount of potential cash, subject to restrictions as defined by the company. These restrictions, such as vesting and non-transferring, attempt to align the holder's interest with those of the business shareholders.

Another substantial reason that companies issue employee stock options as compensation is to preserve and generate cash flow. The cash flow comes when the company issues new shares and receives the exercise price and receives a tax deduction equal to the "intrinsic value" of the ESOs when exercised.

Over the course of employment, a company generally issues employee stock options to an employee which can be exercised at a particular price set on the grant day, generally a public company's current stock price or a private company's most recent valuation, such as an independent 409A valuation[4] commonly used within the United States. Depending on the vesting schedule and the maturity of the options, the employee may elect to exercise the options at some point, obligating the company to sell the employee its stock shares at whatever stock price was used as the exercise price. At that point, the employee may either sell public stock shares, attempt to find a buyer for private stock shares (either an individual, specialized company,[5] or secondary market), or hold on to it in the hope of further price appreciation.

What happens to stock options when you leave a company?

Understanding what happens to your company equity when you quit or otherwise leave your company will depend on your equity type because each can have different implications.

Generally, employee stock options are issued with an expiration date, usually ten years from the grant date. However, every plan is unique and may have its expiration date.

The expiration date is crucial mainly because it is the last day you can exercise your stock option.

If you do not exercise your employee stock option by the expiration date, you lose the ability to exercise it and forfeit any established value. Losing your exercise right can happen even if you remain employed with the company. In other words, paying attention to expiration dates is essential even if you stay with a company.

Should you reward your CEO with stock options?

For incentive compensation to work, corporate boards must choose both the right measures and the right levels of performance. In principle, stock options employ the right measure of performance for corporate executives who are responsible for the company as a whole. After all, the value of a stock option is driven by the share price, which is the largest component of shareholders’ total return. Some managers protest that shareholders’ expectations are unrealistically high, but the weight of evidence does not support that conclusion.

Surveys, for example—whether taken in rising or falling markets—consistently and overwhelmingly report that most CEOs believe their company’s shares are undervalued. Companies are backing up this belief by repurchasing shares at record levels—and studies show that stock prices respond positively to announcements of repurchased shares. In addition, forecasted performance in a company’s own long-term business plans is frequently well above the level needed to justify its current stock price. Finally, companies are increasingly using stock to finance acquisitions. Executives dedicated to increasing shareholder value would not do that if they believed that shares were undervalued. Most CEOs, in short, place a lot of stock in their company’s share price.

If stock options set the right measure of executive performance, do they also set the right level? The answer is no. Shareholders expect boards to reward management for achieving superior returns—that is, for returns equal to or better than those earned by the company’s peer group or by broader market indexes. That is how institutional investors distinguish performing from underperforming companies and also how the Wall Street Journal “Shareholder Scoreboard” compares performance in its annual rankings of the 1,000 largest U.S. companies. To help investors monitor executive pay, the Securities and Exchange Commission even requires companies in their annual executive compensation disclosure to report the total return to shareholders relative to their peers or to the market as a whole. But although many boards and CEOs publicly acknowledge the paramount importance of delivering superior returns to shareholders, current stock option schemes reward both mediocre and superior performance. In other words, boards are not setting the right level of performance.

Who benefits from stock options?

Stock options are an employee benefitthat grants employees the right to buy shares of the company at a set price after a certain period of time. Employees and employers agree ahead of time on how many shares they can purchase and how long the vesting period will be before they can buy the stock. All of this information is included in a contract that both parties sign.

Employees have to purchase the stock before the vesting period ends or they will lose their right to the stock options. Additionally, employees are not obligated to purchase company stock, even if they have stock options. You don’t have to offer stock options to every employee, and many companies choose to offer stock options only for a few key positions.

Stock options are meant to give employees an incentive to work with a company and invest in its growth. They are a cost-effective way to attract talented candidates and encourage them to stay long-term. Employees who own shares of stock have an additional financial incentive for performing well at work beyond their regular salary. They want to help the company grow so the stock price will go up and they can make a significant profit on their initial employment package.

Stock options also can provide protection for employers by requiring the employee to work with the company for a certain period of time before receiving access to their stock options. This protects the company’s equity and can help limit employee turnover.

Stock options are also cost-effective since the business owner offers the future value of their company’s equity instead of cash upfront. They are common in startups when the company may have limited capital to pay employees, so instead, they offer a potentially valuable share of stock at a discount.

Why do employers offer employee stock options?

Can you cash out employee stock options?

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Are employee stock options 100 shares?

Benjamin Beltzer is an early engineer at Berbix (S18), a startup building identity verification and fraud deterrence as a service. He previously founded his own company and worked at both Apple and other startups.

Ben wrote a great resource on understanding and evaluating stock options. With his permission, we’ve shared an excerpt from his piece covering the basics. If you want to learn more about stock options — including valuing them, questions to ask your employer and more. Read the full article on his Medium.

What is the difference between a share and a stock option?

Stocks and options are closely related, but they’re very different things, especially when it comes to how much you can make or lose.

A stock is an ownership stake in a company, and it rises and falls over time depending on the profitability of the business. In contrast, an option is a side bet among traders over what price a stock will be worth by a certain time.

Do you lose stock options if fired?

Pictured: Person checking stocks on phone/Courtesy CC0/MaxPixel

For many biopharma companies, stock options are a great way to find and retain loyal talent, and for employees, stock options are attractive because they signal a potential long-term reward.

Do I keep my shares if I leave the company?

Where do I begin?

I spend a LOT of time talking to people about their spending habits. Here are the biggest mistakes people are making, in my eyes:

Why do executives get stock options?

If CEO stock holdings were replaced with the same ex ante value of stock options, the pay-to-performance sensitivity for the typical CEO would approximately double.

CEOs of the largest U.S. companies now receive annual stock option awards that are larger on average than their salaries and bonuses combined. In contrast, in 1980 the average stock option grant represented less than 20 percent of direct pay and the median stock option grant was zero. The increase in these options holdings over time has solidified the link between executive pay -- broadly defined to include all direct pay plus stock and stock options revaluations -- and performance. However, the incentives created by stock options are complex. To the extent that even executives are confused by stock options, their usefulness as an incentive device is undermined.

Why are executives given stock options?

Executive stock options create incentives for executives to manage firms in ways that maximize firm market value. Since options increase in value with the volatility of the underlying stock, executive stock options provide managers with incentives to take actions that increase firm risk. We find that executives respond to these incentives. There is a statistically significant relationship between increases in option holdings by executives and subsequent increases in firm risk. This relationship is robust to the inclusion of fixed effects, year effects, and a variety of other controls and does not seem to be driven by reverse causality. However, the estimated effect on risk-taking is small and we do not find a negative (or positive) market response to option-induced risk-taking. In sum, although options appear to increase firm risk, there is no evidence that this effect is either large or damaging to shareholders.

Should I accept stock options in my company?

A stock option provides an employee with the opportunity to purchase a set number of shares of company stock at a certain price within a certain period of time. The price is called the “grant price” or “strike price.” This price is usually based on a discounted price of the stock at the time of hire. Buying the stock shares at the grant price is called exercising your stock options.

Remember that you aren’t being gifted shares of the company—you’re being given the opportunity to buy stock or shares in the company. You aren’t required to purchase stock when that opportunity arises, and it will not happen automatically.

As is discussed below, an employee with an option to buy stock must wait for her stock to vest before she can exercise her option to buy shares of the company.

Make certain that the size of your initial option grant is clearly stated in your offer letter and in a separate stock option agreement. An employee’s shares will usually vest over a four-year period, with a one-year “cliff.” This means if—for any reason—you leave your company within the first 12 months, none of your shares will vest.

But after you’ve finished your first year of employment, vesting typically will occur on a monthly basis. If the vesting terms presented to you don’t correspond to these standards, you should ask about it.

Do stock options really motivate employees?

Many business owners find that offering stock options to employees improves morale. When employees are given a share of ownership in the company, they will enjoy coming to work. They know that their efforts will directly impact their financial situation and will be more willing to work together.

What does it mean when your employer offers stock options?

When a company offers stock options to its employees, it is offering them an opportunity to purchase ownership in their company, usually by offering employees the opportunity to buy a specified number of shares of their employer’s stock within a set time period and at a price established by the company.

Do stock options work as an employee incentive?

While employees may not get immediate benefits from stock options, they can get a big payout if they stick with their employer for a certain time, and do good work. While stock options are relatively common among startups, more mature firms are also offering them to retain their workforce as well.

Do stock options really motivate employees?

Many business owners find that offering stock options to employees improves morale. When employees are given a share of ownership in the company, they will enjoy coming to work. They know that their efforts will directly impact their financial situation and will be more willing to work together.

What does it mean when your employer offers stock options?

When a company offers stock options to its employees, it is offering them an opportunity to purchase ownership in their company, usually by offering employees the opportunity to buy a specified number of shares of their employer’s stock within a set time period and at a price established by the company.

Do stock options work as an employee incentive?

While employees may not get immediate benefits from stock options, they can get a big payout if they stick with their employer for a certain time, and do good work. While stock options are relatively common among startups, more mature firms are also offering them to retain their workforce as well.