How Do Employee Stock Options Work? A Breakdown for Small Businesses

Are you looking for a meaningful way for your employees to share in your company's growth? Then you may want to consider employee stock options (ESOs). With an ESO plan in place, your team members can buy shares at a set price. As shareholders, they'll be even more invested in your company's success. Understanding exactly how stock options work helps you build a strong ESO strategy that motivates your team. Let's explore the different types of ESOs and how to structure the best plan for your business.

What are Employee Stock Options?

ESOs are a form of compensation that enables your employees to buy company shares at a fixed price. You introduce them through an employee stock option plan that defines how the program will operate and when employees can purchase shares. Beyond helping your company compete for top talent, stock options can boost team morale and create a stronger sense of ownership across departments. They reinforce your retention strategy by rewarding those employees who stay and contribute to the company's growth and success. An ESO plan brings tax advantages. It can also signal stability during an ownership transition and improve your cash flow.

How do Stock Options Work?

When an employee stock option plan grants options to employees, they receive the right to buy stock at a set price. This number is called the strike price. If the market price rises, they can still purchase at the lower price and may gain from the difference. These options usually become available in stages through a vesting schedule. As part of your company’s overall employee benefits package, the employee stock option plan outlines that schedule in detail. It guides your team on timing and eligibility.

Types of Stock Options: ISOs vs. NSOs

When you consider an employee stock option plan, you’ll often have to decide between two categories: incentive stock options (ISOs) and non-qualified stock options (NSOs). The primary difference lies in their tax implications: 

• ISOs are generally offered only to employees. They can receive favorable tax treatment if employees meet specific holding-period requirements.

• NSOs are more flexible and may be granted to independent contractors, advisors, directors, or other individuals connected to the business. They're usually taxed as income when exercised.

Each option affects your employees' potential gains and tax obligations differently. By learning how they work, you can make choices that benefit your business and your employees.

How to Calculate and Exercise Stock Options 

Exercising an option refers to the employee's right to buy or sell shares at the strike price. If your employees exercise their stock options, they're becoming shareholders. They can decide whether to hold or sell those shares.

To see if exercising their options makes sense, employees should compare the strike price to the current market price of the company’s stock. If the market value is higher, the options may be worth using. The employee stock option plan spells out when employees may exercise their options. Employees should carefully consider how long they intend to hold the shares. They should research the risks they are willing to accept before making a decision.

Tax Levied for Employers and Employees

Taxes play a major role in how stock options work. That's why you and your employees should plan and consider the following:

• Your employees might owe tax when they exercise their options. In some cases, they may face another obligation when selling the shares. The exact outcome depends on the type of option and the length of time the stock is held.

• As an employer, offering employee stock options may result in tax deductions. These require careful reporting.  

Pros and Cons of Offering Stock Options

If you run a small business, an employee stock option plan can help you retain valued workers. It aligns their rewards with organizational performance. At the same time, stock options can introduce challenges. Here's what you need to weigh:

Is Your Business Ready for an Employee Stock Option Plan?

The decision to offer ESOs often depends on whether the benefits of improved retention and aligned incentives outweigh the administrative burden and potential risks. Consider your company's growth trajectory and cash position when you're evaluating employee stock options. You also need to ensure that your team understands and values equity-based compensation.

Creating and Managing a Competitive Benefits Package with Justworks 

For a small business, an employee stock option plan can serve as a motivational tool and a show of confidence in the company’s future. It can be an integral part of your compensation strategy. The right HR tools can help you manage it all. They enable you to record employee stock options and the related taxes. Ready to learn how to implement an ESO plan and reward your team’s contributions? Get started with Justworks today.