What You Need to Know About Employee Stock Option Plans



Stock option plans are a common form of incentive compensation for employees at startups and fast-growing companies. An employee stock option plan (or ESOP for short) is essentially a contract between an employer and employee that gives the employee the right to buy company shares at a fixed price within a specified time period, usually three to five years. An ESOP can be structured in several different ways, but generally, it’s an agreement that offers employees the opportunity to purchase company stock at a discounted rate (known as exercising your options), rather than receiving cash or some other type of compensation. Let’s take a look at what you need to know about employee stock option plans.

What’s the point of an Employee Stock Option Plan?

Employee stock option plans (ESOPs) are generally used to attract and retain employees, especially for start-up companies that lack cash for higher salaries or bonuses. It’s a promise to provide company shares in the future, based on a fair value when the plan is established. It’s important to note that an ESOP is not the same as being a shareholder or owning stock. In other words, an ESOP gives you no rights as an owner until you purchase shares at the end of the plan. A stock option plan can be an effective way to create a sense of ownership and motivate employees to perform better, while also sharing in the risks and rewards of the business. Moreover, it enables the company to attract top talent without paying high cash salaries. It’s important to note that the company can’t grant stock options to just anyone. Stock option plans can only apply to employees.

Stated Equity Value and Exercise Price

In terms of the employee stock option plan, the stated equity value is the amount that would be paid if the employee purchased the shares at the end of the plan. It may be different than the stock’s fair market value when the employee actually exercises the options. The exercise price is the fixed price that an employee would need to pay to buy shares under the plan. You and your accountant will determine the stated equity value and exercise price when you create the plan. The equity value is the amount that would be paid if the employee purchased the shares at the end of the plan. It’s important to note that the employee may actually have to pay a different amount when exercising the options, based on the stock’s value at the time of purchase.

ESOP Conditions and Timing

employee stock option plan

When Can Employees Exercising Their Options?

Employees can exercise their options during a specified time period under the plan. The exercise period is the length of time that an employee has to purchase company shares at the exercise price. In most cases, the exercise period is three to five years. During the exercise period, an employee can purchase company shares by paying the exercise price. The exercise period can be fixed or it can be flexible. In other words, an employee can exercise the options at any time during the specified period. However, there are certain conditions that must be met before an employee can exercise their options. First, the employee must still be employed by the company. Second, the employee must have earned the right to exercise their options, either by working for the company a specified amount of time or meeting other conditions.

How to Determine the Fair Market Value of Company Stock?

Before you establish an employee stock option plan, you and your accountant will determine the fair market value of company shares. You can do this by choosing a date, such as the day you incorporated or initially raised capital for the company. You can also use the day you started trading shares on a stock exchange, such as a public stock exchange. Based on the date, you and your accountant will determine the fair market value of the shares by using a relevant price source, such as a stock exchange price, the NASDAQ (or another exchange), or financial websites. You may also have a financial advisor assess the value of company shares.

Tax Consequences of Exercising Your Options

Before you start buying company shares, it’s important to understand the tax consequences of exercising your options. First, you will have to pay the exercise price. Importantly, it’s taxable income because you are buying shares. Next, you have to pay taxes on the difference between the fair market value and the exercise price. Moreover, you have to pay taxes on the proceeds from selling shares. In other words, you have to pay taxes on the money you make when selling shares acquired through the exercise of the options. You will report the income and taxes on your annual tax return. The company is not required to withhold taxes, nor do they have any responsibility for taxes on exercised options. It’s your responsibility to pay the appropriate taxes. It’s important to note that the tax consequences of exercising your options may differ, depending on your individual circumstances, such as your income tax bracket, whether you own other company shares, and how long you hold the shares.

Final Words: Is an Employee Stock Option Plan Right for You?

Employee stock option plans (ESOPs) are common at startup companies, particularly those that lack cash for higher salaries and bonuses. It’s a promise to provide company shares in the future, based on a fair value when the plan is established. It’s important to note that an ESOP is not the same as being a shareholder or owning stock. In other words, an ESOP gives you no rights as an owner until you purchase shares at the end of the plan. A stock option plan can be an effective way to create a sense of ownership and motivate employees to perform better, while also sharing in the risks and rewards of the business. Moreover, it enables the company to attract top talent without paying high cash salaries.

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