How Do Employee Stock Options Work? Benefits and Considerations

With many companies facing higher rates of employee turnover, and the need to embrace digital transformation and smarter recruitment, many business leaders are looking at ways that they can attract, retain and motivate their teams. 

As far as talent acquisition and retention are concerned, employee stock options are becoming an increasingly popular solution that companies could consider. By providing employees with a marginal ownership stake, businesses can give team members a tangible way to share in the firm’s future success. Coupling this in line with the company’s goals and incentives can be an increasingly attractive prospect for new employees, and a way to safeguard current teams. In some cases, companies can even become entirely staff-owned.

However, designing and implementing business stock option plans requires care to balance the interests of shareholders and employees. There are also legal formalities to get right under UK law, as failing to do so could potentially land companies in hot water. This article will explain how employee stock options work, key terminology, legal issues to consider, and an overview of the main pros and cons.

What Are Employee Stock Options and Shares?

Employee stock options give staff the chance to acquire shares in the company they work for. The primary feature is the ‘option’ to buy company stock at a pre-agreed price, known commonly as the ‘strike’ or ‘exercise’ price.

These options are issued according to a vesting schedule. For instance, companies may explicitly grant the right for employees to purchase 25% of the shares after one year, and then monthly thereafter. Once these shares vest, the employee can decide whether they want to exercise the option to buy them. 

The incentive behind employee stock options lies in the potential of making profits if the share’s market value rises above the strike price. For example, if stock prices double above the strike price, employees could potentially make huge returns if they exercise the options. 

However, forecasting market performance is not easy, but if a company is transparent about its ambition, many talented individuals could be tempted by the prospect of sharing in its success.

Each company’s approach to administering employee stock options varies, and there is no universal vehicle for immediate success. 

Is There a Key Difference Between Share and Stock Options?

This is where some of the commonly-used terminology around employee stock options can become a little convoluted. 

The term ‘stock options’ is often used interchangeably with ‘share options’. Share options specifically give the holder the right to acquire shares at the exercise price on a future date. 

However, there are also some crucial differences from being gifted shares upfront, which are important to understand:

• By taking share options, you are not immediately a shareholder. You only own the underlying shares once exercised.
• You must pay the exercise price to turn the options into shares, and you may be given a deadline with which to pay.
• The exercise price is locked-in upfront, which is helpful to keep in mind. This will limit the downside and also maximise your share gains if ‌stock prices rise.

Some companies may welcome employees to take stock options, whereas others may be willing to give shares. It entirely depends on the organisation that you work for and what their specific policies are.

To summarise:

• Stock options represent the right to buy shares at a locked, preset price. 
• Share awards involve receiving shares without payment.

Key Legal Considerations of Employee Stocks and Shares

There are several important legal issues with stock and share options that companies need to be mindful of:

• Tax – Share schemes (including options under the Enterprise Management Incentive scheme) must be structured so that the correct taxes are implemented. It’s advisable for firms to consult specialist EMI legal advice to ensure policies are watertight and legally compliant. 
• Compliance – Any stock or share arrangements must comply with – and not contradict – existing company law and pre-existing policies, such as getting shareholder approval for equity dilution. Issuing more shares could dilute existing shareholders, so a careful balance must be struck.
• Employment rights – Care is needed around granting shares to employees without unfairly diluting other investors or existing shareholders. Companies must be forthcoming about plans to alter schemes if they could affect any incumbent shareholders’ positions.
• Definitive and universal – The plan’s rules around vesting, exercise windows, and eligibility need to be robust and clearly defined. No employee, if eligible, should be kept in the dark about their options and deadlines. 

Key Terminology With Employee Stock Options

• Vesting schedule – The timeline when options become exercisable. For example, 25% after one year, and then monthly. This schedule prevents employees from leaving immediately after being granted options.
• Exercise window – This refers to the timeframe in which employees can exercise their vested options. It provides some flexibility over when to acquire shares, but also means that employees cannot necessarily exercise all at once.
• Expiration date – The last date that options can be exercised, after which they lapse. This date typically falls approximately 10 years from the date the shares are granted.
• Strike or exercise price – The fixed price to pay per share on exercise. The price shouldn’t be lower than the market value when options are granted.
• Time vesting – Vesting opportunities based on length of service, for example, monthly vesting over 4 years.
• Performance vesting – Options vesting based on hitting targets like revenue or sales targets being exceeded.

Benefits and Drawbacks of Employee Stock Options

While it’s hopefully clear that employee stock options have some key advantages, there are some considerations to be mindful of, as well:

Benefits of Employee Share Options

• Attraction of talent – Options help recruit valuable talent in competitive industries, which can be particularly difficult to find.
• Retention of staff – Vesting schedules incentivise staff to stay with companies for longer periods to gain more equity.
• Alignment – Giving employees an ownership stake aligns with shareholders, if schemes are executed correctly.
• Tax efficiencies – Options can provide tax advantages under schemes like EMI, provided that policies are legally compliant.
• Upside potential – Huge gains if the share price rises significantly above the exercise price.

Drawbacks of Employee Share Options

• Complexity – Administration and communicating policies can be challenging, and it’s even more difficult to align this strategy with employee expectations.
• Potential dilution – Offering greater numbers of options runs the risk of potentially diluting existing shareholders, which can lead to dissension and dissatisfaction.
• Motivational issues – Employees may not be tempted by financial gains and so a certain percentage of talent may not feel any more inclined to stay on board, especially if the market is fluctuating and offers little peace of mind.
• No guarantees – Staff may get no benefit if shares remain below the exercise price.
• Tax implications – Getting tax relief depends on strict qualifying rules, which is why it’s crucial that employers consult legal advice.

Overall, employee stock options can be highly effective at aligning incentives between staff and shareholders when structured appropriately. The ability to share in a firm’s growth can increase motivation and performance. However, designing the optimal scheme requires a solid level of understanding and empathy to balance the interests of employees and investors.