What Is an Employee Stock Option (ESO)?

A stock option is a grant to an employee of the right to buy a certain number of shares in the company's stock for a set price at a future date. If the stock price increases above the options price, the employee cashes in.

Stock options are a benefit most often associated with startup companies, which may issue them in order to reward early employees when and if the company goes public. They are awarded by some fast-growing companies as an incentive for employees to work towards growing the value of the company's shares.

Stock options also serve as an incentive for employees to stay with the company. The options are canceled if the employee leaves the company before they vest.

Understanding the ESO

An employer who grants stock options awards the employee a number of options at a set price (the "strike price" or "exercise price"). The options may be exercised after a specified date. They are "vested" at that date, meaning ownership of the options is transferred to the employee.

If the stock price has increased, the employee may buy shares at the strike price and sell them at the market price, pocketing the difference. Some companies complete the deal directly with their employees to save them the trouble and expense of the market transaction.

An employee stock option is similar to a call option on a company's stock, as it confers the right but not the obligation to buy the stock. Unlike listed or exchange-traded options, employee stock options are issued by the company and cannot be sold.

Employee stock options are a form of equity compensation granted by companies as an incentive for employees to work towards the common objective of maximizing shareholder value.

Stock options in themselves do not give the employee shareholder rights such as dividends or votes. If a company awards stock options, the terms and conditions are generally set out in the company's Employee Stock Option Plan (ESOP).

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Stock Option

Calculating the Value of Stock Options

The value of stock options when they are awarded is unknowable. It depends on how well the company's stock is performing at a future date.

However, the theoretical value of options can be calculated using a formula such as the Black-Scholes model. This model was designed to estimate the effects of the price variation of assets over time. When applied to a stock option, the formula incorporates factors including the constant price variation of the stock, the time value of money, the option's strike price, and the time to the option's expiry.

Those who don't want to tackle the Black-Scholes model can find options profit calculators online. Most online trading platforms have robust options analysis tools, including indicators and spreadsheets that perform the calculations.

Example of a Stock Option Agreement

A company may grant an employee the option to purchase 1,000 shares of company stock at a strike or exercise price of $50 per share. Half of the shares vest after two years and the other half vest at the end of three years.

Assume that the stock price rises to $70 after two years. The employee can purchase the 500 shares that are vested at $50 and then sell those shares at the market price of $70. The transaction generates a $20 per share gain, or $10,000 in total. The firm has retained an experienced employee for at least two years, and the employee has profited.

What if the stock price doesn't rise above the $50 exercise price? In that case, the employee does not exercise the stock options. Perhaps the company's stock price will rise down the road. The options may be worth something down the road. And, the remaining 500 shares will vest in another year. If the employee stays with the company for two more years, those options too may be valuable.

ESOs are an expense to the employer, and companies post the cost of issuing the stock options to their income statements.