An employee stock option (ESO) is a privately awarded call option, given to corporate employees as an incentive for improving a company’s market value, which cannot be traded on the open market. ESOs give employees a right (without obligation) to purchase a predefined amount of shares of the company at the current, or strike, price, within a certain time frame, after which the options expire worthless. This time limit, or exercise period, is commonly ten years.

If the company’s stock price rises within the exercise period, the employee can exercise the ESO by simultaneously buying the discounted shares and selling them at the higher market price. However, the same cannot be done if the stock drops below the strike price therefore, ESOs are used by companies in lieu of high salaries as encouragement for the individual employee to increase the company’s value. There are three main kinds of ESOs non-statutory, reload and incentive options.

A non-statutory ESO, also known as a non-qualified ESO, is the standard type of ESO. It stipulates that an employee cannot exercise the option within a “vesting” period of one to three years, and earns the difference between the strike price and the current price, multiplied by shares sold. Non-statutory ESOs cannot qualify for capital gains tax rates, and are taxed at the full income tax rate, included in the alternative minimum tax (AMT) in tax returns.

It is important to remember that although most non-statutory ESOs become exercisable within a one to three year vesting period, some are locked with a “graduated vesting” scheme known as phased vesting. This means that the employee will be able to exercise a small percentage of options, such as 10%, in the first year and be able to exercise 20% after two more years, and so on.

A reload ESO starts out like a non-statutory ESO, but upon the initial exercise of the ESO, in which the employee earns a profit, the employee is awarded with a “reload” of the ESO, with new options issued with the current market price becoming the new strike price.

Incentive Stock Options

An incentive stock option (ISO) is subject to additional rules designed to minimize taxes. The employee must wait at least a year before exercising the option to buy the stock, but not sell it for at least a year after the purchase. This differs substantially from the simultaneous buy-and-sell exercise of non-statutory ESOs, and imposes a higher risk due to the uncertainty of the one-year stock holding period, as the stock may decline in the value. However, ISOs are taxed substantially less than non-statutory ESOs at a long-term capital gains tax rate, rather than an income tax rate. ISOs are generally awarded to higher management.

Considerations Before Exercising Options

Generally, employees will sit on their stock options for as long as possible before exercising options, unless they have reload options, in order to maximize their value. However, in the aftermath of the dot-com bubble and the subsequent tech crash of 2001, it is wise for employees to remain well informed about the financial health of their company.

In times of financial turbulence, as in the global financial crisis of 2008-2009, companies often reprice their ESOs in a variation of the reload ESO. For example, if a company’s ESOs originally had a strike price of $20 and the shares had fallen to $10, the company has the right to cancel all the initial ESOs before the exercise period ends, then issue new ESOs with $10 as the new strike price. This practice is designed to maintain corporate morale even as the company’s value declines.

In order to exercise an ESO, an employee can either pay cash, swap with previously owned employer stock, or to simultaneously borrow money from a brokerage and sell enough shares to cover the transaction.