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What is an 'Employee Stock Option - ESO'

An employee stock option (ESO) is a stock option granted to specified employees of a company. ESOs offer the options holder the right to buy a certain amount of company shares at a predetermined price for a specific period of time. An employee stock option is slightly different from an exchange-traded option, because it is not traded between investors on an exchange.

BREAKING DOWN 'Employee Stock Option - ESO'

Employees typically must wait for a specified vesting period to pass before they can exercise the option and buy the company stock, because the idea behind stock options is to align incentives between the employees and shareholders of a company. Shareholders want to see the stock price increase, so rewarding employees as the stock price goes up over time guarantees that everyone has the same goals in mind.

How a Stock Option Agreement Works

Assume that a manager is granted stock options, and the option agreement allows the manager to purchase 1,000 shares of company stock at a strike price, or exercise price, of $50 per share. 500 shares of the total vest after two years, and the remaining 500 shares vest at the end of three years. Vesting refers to the employee gaining ownership over the options, and vesting motivates the worker to stay with the firm until the options vest.

Examples of Stock Option Exercising

Using the same example, assume that the stock price increases to $70 after two years, which is above the exercise price for the stock options. The manager can exercise by purchasing the 500 shares that are vested at $50, and selling those shares at the market price of $70. The transaction generates a $20 per share gain, or $10,000 in total. The firm retains an experienced manager for two additional years, and the employee profits from the stock option exercise. If, instead, the stock price is not above the $50 exercise price, the manager does not exercise the stock options. Since the employee owns the options for 500 shares after two years, the manager may be able to leave the firm and retain the stock options until the options expire. This arrangement gives the manager the opportunity to profit from a stock price increase down the road.

Factoring in Company Expenses

ESOs are often granted without any cash outlay requirement from the employee. If the exercise price is $50 per share and the market price is $70, for example, the company may simply pay the employee the difference between the two prices multiplied by the number of stock option shares. If 500 shares are vested, the amount paid to the employee is ($20 X 500 shares), or $10,000. This eliminates that need for the worker to purchase the shares before the stock is sold, and this structure makes the options more valuable. ESOs are an expense to the employer, and the cost of issuing the stock options is posted to the company's income statement.

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