Employee Stock Options — Definition

Employee Stock Options are stock options granted to employees by their companies as a form of compensation or incentive.

Employee Stock Options — Introduction

How Does Employee Stock Options Work?

Employee Stock Options — Simplified Example

Let’s assume that you are granted employee stock options to buy 100 shares of your company stocks at $40 while it is trading at $40 now. You are only allowed to exercise the rights vested in those employee stock options 1 year later (vesting period of 1 year). 1 year later, your company did well, have great earnings and its shares soared upwards to $50. You could now exercise your right to buy 100 shares at $40 through the employee stock options, making the difference of $10 as profit. You could then decide to sell those shares for an immediate $10 per share profit or you could continue to hold on to those shares for potential future capital gain.

Employee Stock Options — Terminology

Grant (also known as strike price, option price or exercise price)

The price at which you can buy shares of the company no matter how far it has moved in the future.

Holder

Owners of employee stock options. You are the holder of your employee stock options.

Expiration date (also known as Maturity)

The date by which you must exercise the right to buy shares of the company or let the employee stock options laspe worthless.

Vesting Period

The period of time within which you cannot exercise the right to buy shares of the company. Vesting periods can be as long as several years before the employee stock options becomes fully vested.

Vested Options

Employee Stock Options that are fully vested and ready for exercising after fulfilling the vesting period.

Waiting Period

The period of time within which you cannot sell the shares bought through exercising the employee stock options. It can range from several days to several months.

In The Money

When the shares of the company is higher than the grant. Read more about In The Money Options.

Out Of The Money

When the shares of the company is lower than the grant, making the employee stock options worthless upon expiration. Read more about Out Of The Money Options.

There are 2 main types of employee stock options and they are known as Incentive stock options (ISOs) and Nonqualified stock options (NSOs).

Incentive Stock Options (ISOs)

Incentive Stock Options or ISOs are employee stock options that allows the employee to defer paying a tax on the unrealized profits until the shares bought with the employee stock options are sold. The company issuing Incentive Stock Options (ISOs) do not receive a tax deduction.

Nonqualified Stock Options (NSOs)

Nonqualified Stock Options or NSOs are employee stock options that requires the employee to pay a tax on the unrealized profits in the shares bought with the employee stock options. The company issuing Nonqualified Stock Options (NSOs) recieves a tax deduction on those unrealized profits.

Clearly, employees would always prefer to recieve Incentive Stock Options.