How do employee stock options work?

The short version

• Employee stock options give the worker the right to buy shares at a specific price in the future.
• Stock options are a common part of compensation, most notably for company executives and managers.
• The value of employee stock options is tied to the future value of the company’s stock.

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What are employee stock options?

Employee stock options are a type of compensation workers may get at private and public companies. Stock options allow the worker to buy stock in the company on a specific future date at an exact future price. If the stock is worth more than the stock option price on that date, the stock options can be exercised and cashed in for a profit. But if the stock price has gone down, the stock options are worthless.

Employee stock options are good for workers because they can make money when the company stock goes up. If the company succeeds, the worker succeeds. In stock options benefit the employer because they increase employee loyalty and engagement and give the employees a good reason to work hard, and improve the company‘s stock price.

However, the big downside of employee stock options is that they're not always worth something. If the company stock price has gone down since your employee stock options were issued, the options are called “out of the money” and are essentially worthless. Also, similar to some other employee compensation plans, employee stock options generally require a vesting period. With vesting, a worker must be at the company for a minimum of time to access the employee stock options.

Overall, employee stock options are often a win-win for the company and the employees. That makes them widely-used among companies around the world.

Many of the world's largest companies include stocks options as part of their compensation packages. In some cases, stock option eligibility may be restricted to only those who are members of the executives team. But they're typically open to everyone. Tesla employee stock options, for example, are even open to interns who work at least 20 hours per week.

How are stock options different from other stock purchase plans?

Employee stock options are not the same as restricted stock units. Restricted stock units (RSUs) are a type of compensation where the employee is given full shares of stock and does not have to make any type of purchase.

These are more expensive for employers but are also better for employees. RSUs typically vest over a period of time. For example, the Amazon RSU vesting schedule is 5% after year one, 15% after year two, and 20% every 6 months for two years.

With RSUs, the employee gets the value from the stock whether or not the share price goes up or down. With employee stock options, the employee only makes money when the stock price increases — and only profits by the amount of the increase. Restricted stock units are rarely worthless, while employee stock options are regularly not valuable.

More: Stock options vs. RSUs: Key differences between the two

An employee stock ownership plan (ESOP) is another stock award system. With this type of stock compensation plan, employees receive shares in the company similar to RSUs. ESOPs are most common with smaller, privately held companies. In many ways, RSU and ESOP plans are very similar, as the employee is awarded shares in the company.

Stock grants are another popular stock purchase plan that typically require employees to work a certain amount of time before they can receive an allotment of shares. Apple has famously used this model for years. And, finally, some companies offer stock discounts. For example, GoDaddy allows employees to buy its stock shares at a 15% discounted rate.

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How do you determine the value of your employee stock options?

As with other options investments, employee stock options are either “in the money” or “out of the money,” depending on the current stock price. As stated above, if the stock price has gone up since the options were issued, the options are considered “in the money” and can be sold immediately for a profit. They can also be exercised in a way so that the employee can keep the shares.

If you have employee stock options and don’t need the funds immediately, it’s not a bad idea to hold on to shares of the company's stock if you believe its share price will go up. However, don’t put all of your eggs in one basket and put too much of your portfolio into one stock, even if it’s the company you work for.

Here's an example to help you better understand the value of employee stock options. Let’s say you work at a company and receive stock options for 100 shares. When the options were issued, you noticed a listed price of $50 per share. That is the key data point to determine what your employee stock options are worth.

On the exercise date in the future, let’s say the stock has gone up to $60, an increase of $10 per share. That would make your options worth $10 x 100 shares or $1,000. You can follow the same logic with your employee stock options to find what they’re worth.

How does vesting and selling work?

Vesting is a process that allows employees to earn a benefit over time. In many cases, employee vesting takes place over a period of years. The employee will generally get access to a portion of their options periodically, with the full value available on the final vesting date.

Once the options have vested, if the options are in the money, the employee can exercise the options and either keep the shares, which means they have to spend money to buy them, or sell them immediately for a profit. If you've ever traded in the options markets, the exercise process, strike price, and strike date work similarly.

More: Trading options vs. stocks

How are employee stock options taxed?

Employee stock options have a similar tax treatment to other stock investments. There are no taxes when your options are issued. Instead, taxes kick in when you sell the stock for a profit or loss.

If you hold the stock for less than one year, profits are taxed as a short-term capital gain. If you have the stock for longer than one year, the proceeds are treated as a long-term capital gain.

More: Long-term vs. short-term capital gains tax

Bottom line on employee stock options

Employee stock options are an excellent employment perk that also keeps employees engaged in their job, making them a win-win scenario for workers and employers. If you're lucky enough to have access to stock options from your job, pay close attention to how they work and follow your company's stock price to track how much your options are worth over time. If you stick with your employer for a long time and the stock does well, those options might be worth more than your salary!

There is no perfect form of employee compensation. Some would argue that restricted stock units or employee stock purchase plans are better for the employee because they get the entire value of the shares rather than just stock price increases. However, you shouldn’t be quick to dismiss your employee stock options. They're another way for your company to compensate you for the hard work you do every day.

Further reading:

• 7 most popular employer-sponsored retirement plans
• What does it mean to be vested in a 401(k)?
• 401(k) options when you leave your job