What are Employee Stock Option Plans?
Employee stock option plans make headlines when company executives receive large compensation in exchange for their services. These compensation plans often include stock option plans in addition to the base salary. Some companies offer employee stock option plans to employees at lower levels of the company as well. Anyone receiving an employee stock option plan needs to understand what these plans consist of.
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Stock Options Plans
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Stock options represent the right of the holder to purchase shares of stock at a predetermined price. Each stock option comes with an identified future time frame during which the holder can exercise the option. Stock option plans exist when companies offer employees the right to purchase a specific number of shares at the exercise price. The expectation is that the stock price will increase beyond the exercise price associated with the option. When an employee does not exercise the stock option, it expires.
Reasons for Offering Stock Option Plans
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Companies offer employee stock option plans to give employees incentives to work for the company rather than a competitor. Companies often offer stock options when they lack the funds to pay a higher salary. Employee stock option plans increase the compensation package offered to these employees without incurring additional cost to the company.
Companies also offers stock options to motivate employees to take a vested interest in the company's success. The stock market price increases as the company's performance increases. The higher the stock market price, the more the stock options are worth. The more the employee focuses on increasing the company's performance, the more her stock options will be worth.
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Types of Stock Options
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Companies issue two different types of stock option plans to employees. Each type differs in the tax treatment of the value difference between the exercise price and the market price. The first type, non-qualified stock options, require the holder to pay income tax when he exercises the options. The income is calculated on the difference between the exercise price and the current market price. The holder also pays income tax on any gains experienced before he sells the stock. The second type, incentive stock options, require no income tax payment until the holder sells the stock. At that time the holder pays income tax on the difference between the exercise price and the final selling price.
Exercising Stock Options
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When the time arrives to exercise the options, the employee needs to decide how to proceed. If the stock price has decreased below the exercise price, she receives no benefit in exercising the options and should let the options expire. If the stock price has increased above the exercise price, the employee profits based on the difference between the exercise price and the current market price and should exercise the option.
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