Whereas incentive stock options are only taxed when selling and potentially taxed at the capital gains rate , non-qualified stock options are taxed when exercising and selling your shares. Non-qualified stock options are more common than incentive stock options. It is important for both startup founders and early employees it is important to understand how employee stock options work.

Employee Stock Option (ESO)

The different tax structures, terminology, and legal documents can make it an intimidating task. As stock options are an integral part of startup culture there are a few terms and ideas that everyone should be familiar discussing. Generally when signing a job offer you will receive an offer grant. It is important to remember that stock options are not actual shares of stock but rather the option to buy these shares at a set price on a later date.

So how do you make money on stock options? When the price between the offer or grant price the price you can buy the shares at and the market value of the company rises. At the time of receiving an offer letter you will also receive a stock option agreement. This document will include different dates, terms, and details that are pertinent to your grant. This includes what type of options you will receive, number of shares, vesting schedule, and the expiration date. Vesting is a mechanism that companies can use to encourage employees to stay longer.

As we mentioned earlier when you receive a stock option this is not actual shares but rather the ability to buy shares at a later date.

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In order to retain employees, most companies will include a vesting schedule with their offer. This is the schedule in which you will have the ability to exercise your shares. A vesting schedule usually takes place over a period of time and may be split over the course of a few years or milestones. The most common vesting schedule for startups is a time-based schedule.

The most common startup setup is a 4 year vesting schedule with a 1 year cliff. This means that after working for a company for a full year, the employee will receive the first quarter of their shares 1 year cliff. After the first year, the employee will receive their remaining shares over the next 3 years on a specific calendar. There are clear pros and cons of employee stock options. Generally speaking the benefits of ESOs outweigh the cons. From the perspective of a startup, the benefits of ESOs are quite clear. Generally speaking startups are strapped for cash and may not be able to compete with larger firms hiring for the same positions.

When top talent is evaluating where to work they are generally looking for a few things: ownership, collaboration, transparency, and growth. Ownership can come in 2 forms, ownership in their work and ownership in the company. Offering ownership in the form of stock options is a surefire way for a startup to find and retain top talent. At the end of the day, early startup employees are taking a risk and likely a paycut to join a team that is attacking an interesting market or building a strong product.

Rewarding talent for taking the risk is a must for early stage startups.

Employee Stock Options Guide for Startups |

As we alluded to above, the pros of offering employee stock options are quite clear for a startup. On top of the ability they can be used as a tool to attract and retain top talent there are a few other pros:. However, with pros comes cons. While not as plentiful as the pros of offering employee stock options there still are cons of offering ESOs.

As we mentioned above, there are still cons when it comes to startups offering employee stock options. A few common cons startups often see with employee stock options are:. While the pros generally outweigh the cons of offering employee stock options. There still are cons that startups and founders need to work through when it comes to offering stock options as a form of employee compensation at their company.

Deciding when and how to issue employee stock options can be a difficult task. A startup or founder needs to understand how much they should pay employees in cash and then add in stock options. When setting out to issue stock options it probably looks something like this:. As we mentioned above the tax benefits, or lack thereof, are an integral part of employee stock options. To recap here, the main difference comes between incentive stock options and non-qualified stock options.

Employee Stock Options: How They Work and What to Expect

On one hand, we have incentive stock options. ISOs offer many tax benefits. ISOs are only taxed when selling the shares of stocks — and only taxed at the capital gains rate which is generally less than ordinary income tax. On the other hand, we have non-qualified stock options. While more common, NSOs do not offer the same tax benefits as incentive stock options.

NSOs are taxed both when exercising and selling. But what happens when ESOs are actually exercised? Opponents of expensing options also claim that doing so will be a hardship for entrepreneurial high-tech firms that do not have the cash to attract and retain the engineers and executives who translate entrepreneurial ideas into profitable, long-term growth.

This argument is flawed on a number of levels. For a start, the people who claim that option expensing will harm entrepreneurial incentives are often the same people who claim that current disclosure is adequate for communicating the economics of stock option grants. The two positions are clearly contradictory. If current disclosure is sufficient, then moving the cost from a footnote to the balance sheet and income statement will have no market effect.

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More seriously, however, the claim simply ignores the fact that a lack of cash need not be a barrier to compensating executives. Rather than issuing options directly to employees, companies can always issue them to underwriters and then pay their employees out of the money received for those options. Considering that the market systematically puts a higher value on options than employees do, companies are likely to end up with more cash from the sale of externally issued options which carry with them no deadweight costs than they would by granting options to employees in lieu of higher salaries.

Even privately held companies that raise funds through angel and venture capital investors can take this approach. The same procedures used to place a value on a privately held company can be used to estimate the value of its options, enabling external investors to provide cash for options about as readily as they provide cash for stock. But that does not preclude also raising cash by selling options externally to pay a large part of the cash compensation to employees.

We certainly recognize the vitality and wealth that entrepreneurial ventures, particularly those in the high-tech sector, bring to the U. A strong case can be made for creating public policies that actively assist these companies in their early stages, or even in their more established stages. The nation should definitely consider a regulation that makes entrepreneurial, job-creating companies healthier and more competitive by changing something as simple as an accounting journal entry.

After all, some entrepreneurial, job-creating companies might benefit from picking other forms of incentive compensation that arguably do a better job of aligning executive and shareholder interests than conventional stock options do. Indexed or performance options, for example, ensure that management is not rewarded just for being in the right place at the right time or penalized just for being in the wrong place at the wrong time. A strong case can also be made for the superiority of properly designed restricted stock grants and deferred cash payments.

Yet current accounting standards require that these, and virtually all other compensation alternatives, be expensed.

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Are companies that choose those alternatives any less deserving of an accounting subsidy than Microsoft, which, having granted million options in alone, is by far the largest issuer of stock options? A less distorting approach for delivering an accounting subsidy to entrepreneurial ventures would simply be to allow them to defer some percentage of their total employee compensation for some number of years, which could be indefinitely—just as companies granting stock options do now. That way, companies could get the supposed accounting benefits from not having to report a portion of their compensation costs no matter what form that compensation might take.

How stock options work

Although the economic arguments in favor of reporting stock option grants on the principal financial statements seem to us to be overwhelming, we do recognize that expensing poses challenges. For a start, the benefits accruing to the company from issuing stock options occur in future periods, in the form of increased cash flows generated by its option motivated and retained employees. The fundamental matching principle of accounting requires that the costs of generating those higher revenues be recognized at the same time the revenues are recorded.

This is why companies match the cost of multiperiod assets such as plant and equipment with the revenues these assets produce over their economic lives. In some cases, the match can be based on estimates of the future cash flows. In expensing capitalized software-development costs, for instance, managers match the costs against a predicted pattern of benefits accrued from selling the software.

In the case of options, however, managers would have to estimate an equivalent pattern of benefits arising from their own decisions and activities. That would likely introduce significant measurement error and provide opportunities for managers to bias their estimates. We therefore believe that using a standard straight-line amortization formula will reduce measurement error and management bias despite some loss of accuracy.

The obvious period for the amortization is the useful economic life of the granted option, probably best measured by the vesting period. This would treat employee option compensation costs the same way the costs of plant and equipment or inventory are treated when they are acquired through equity instruments, such as in an acquisition. In addition to being reported on the income statement, the option grant should also appear on the balance sheet. Some experts argue that stock options are more like contingent liability than equity transactions since their ultimate cost to the company cannot be determined until employees either exercise or forfeit their options.

This argument, of course, ignores the considerable economic value the company has sacrificed at time of grant. At time of grant, both these conditions are met. The value transfer is not just probable; it is certain. The company has granted employees an equity security that could have been issued to investors and suppliers who would have given cash, goods, and services in return. The amount sacrificed can also be estimated, using option-pricing models or independent estimates from investment banks.

There has to be, of course, an offsetting entry on the asset side of the balance sheet. FASB, however, subsequently retracted its proposal in the face of criticism that since employees can quit at any time, treating their deferred compensation as an asset would violate the principle that a company must always have legal control over the assets it reports.