Public and private companies use Incentive Stock Options, or ISOs, to attract and retain key staff. Although the law allows any employee to participate in such plans, these options are typically granted to high-level employees and convey the right to buy company shares at a fixed price and within a predetermined time frame. Significant tax benefits also accrue, subject to specified terms and conditions. Given the substantial investment in training employees, companies look to such options as a way to keep their best-performing workers.
Lack of Risk
Employees granted ISOs cannot lose any out-of-pocket money, and they stand to reap considerable gains if the company does well during the course of their employment. An ISO grants the recipient the opportunity, but not the obligation, to buy company stock at a fixed price. So if the stock remains at the same level or declines in value, the employee can simply let the option lapse. Even when this happens, though, companies will often set a lower strike price in an attempt to maintain the incentive.
Time Frame and Taxes
Even though ISOs are designed as tax-advantaged benefits, any realized gains can be taxed at either the ordinary income-tax rate or the long-term capital gains rate, which at 15 percent is significantly lower. For employees to take full advantage of these plans, they must wait for at least two years after the date of the original option grant before selling any shares, and one year after actually acquiring them.
A key advantage to the employer in offering ISOs is the ability to defer compensation by offering stock rather than cash. Start-up companies find this feature especially useful when trying to attract and retain the best employees, as capital is usually at a premium. Even well-established companies often prefer to use their cash as much as possible toward product development and expansion rather than for salaries. Less cash may be detrimental to employees, but if their individual circumstances permit them to hang in there, the rewards are often substantial.
ISOs provide employees with a direct ownership stake in their companies, a circumstance that cannot help but enhance their efforts and commitment on behalf of the overall organization. From customers and suppliers to in-house staff, owners generally accept a high level of personal responsibility and accountability in working to exceed performance goals. When the company does well, not only do their shares increase in value, but the implementation of stock dividends directly enhances income. A possible disadvantage comes into play if the shares vest only after a multi-year time span. This can tie employees to a company that may not be doing well, or may experience a decline in fortunes after an initial burst of success.