Employee Stock Option Basics

Many corporations use employee stock options (ESO) as an incentive and reward for senior personnel and executives. An ESO is like the call options traded on the Chicago Board of Options Exchange and elsewhere, except an ESO cannot be bought and sold on the open market. The option confers the right (but not obligation) to purchase a specified number of shares of the company stock at a certain price, called the strike price, until the option expires (normally several years. If the company's stock goes up in value, the employee can exercise the option, buying the shares at a bargain price and then reselling them at the higher market price, pocketing the difference.

Types

The most common forms of employee stock options are non-statutory, incentive and reload options. A non-statutory ESO is the basic form. The term "non-statutory" distinguishes the basic ESO from incentive stock options (ISO). With an ISO, the employee can take advantage of capital gains tax rates on any profits (a non-statutory ESO does not qualify for capital gains). Reload options allow the employee to exercise the option and then be issued a new option to replace it.

Non-statutory ESO

Normally, when a company awards an employee a non-statutory ESO, there is a stipulation that the employ must wait a period of time (one to three years is typical) before exercising the option. The employee can exercise the option if the company stock appreciates, buying shares at the strike price and then selling the shares at the market price. For example, if the strike price is $20/share and the stock has risen to $30/share, the employee nets the difference of $10/share.

Incentive Stock Options

Provided the employee follows certain rules, she can qualify for capital gains tax rates with an incentive stock option. Under federal regulations, the employee must wait at least one year after being issued the option before exercising it, and then must hold the stock for one additional year before selling it. This holding period imposes a risk (the stock could go down in value) but offers a substantial tax savings.

Reload ESO

Employee stock options with a reload feature permit the employee to exercise the option if the company's stock goes up, taking the profit to date. Then the company issues a new option for the same number of shares and with the same expiration date, but with the current market price of the stock as the strike price. If the stock continues to grow in value, the employee can exercise the option again, collecting more profit.

Cashless Exercise

In theory, an employee must pay the strike price in order to exercise an ESO. In practice, the transaction is carried out as a "cashless exercise." The employee delivers the options to his broker. The broker (for a small fee) "loans" the money to buy the stock, and then immediately sells the shares on the market, recovering the loaned money and depositing the profits into the employee's brokerage account.