Employee stock options (ESOs) signify contracts between a company and its employees, which give employees the right to buy (exercise) a specific number of the company’s shares at a fixed price (the grant, strike, or exercise price) within a certain period of time (the “”exercise”" period). Both public and private companies utilize ESO schemes. Employees who purchase stock options expect to profit by exercising their options at a higher price than that at the time they were granted.
An example of a typical employee stock option plan follows: an employee is allowed the option to buy 1,000 shares of the company’s stock at the present market price of $5 (the grant price) per share. The employee can purchase the option at $5 per share; normally the exercise price (strike price) will be equal to the value when the options are granted. ESO plans permit employees to exercise their options after a certain period of time or when the stock of the company attains a certain price. If the stock’s market price increases to $20 per share, for instance, the employee is granted an opportunity to buy 1,000 shares at $5 and then sell the stock at the existing market price of $20.
Occasionally, the company revalues the grant price of the stock options, this may usually occur when its stock price has fallen below the original exercise price.
Incentive stock options (ISOs) that are qualified options or statutory options, and nonqualified stock options (NSOs) are the ESO types. The ISO plans allow employees to defer taxation until the shares bought with the option are sold. The company does not collect a tax deduction for this type of plan.
The employees in the nonqualified stock options (NSOs) should pay ordinary income tax on the difference between the grant price and the price at which they exercise the option. NSO do not meet all the requirements of the Internal Revenue Code (IRC), to be qualified as ISOs.
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