Group of employees sitting in a circle for a brainstorming session.
Employee stock options are often used to incentivize workers to stay long-term and contribute toward business growth, but they may not be a good solution for every business. — Getty Images/Tom Werner

Public and private companies may offer forms of equity compensation, including employee stock option (ESO) plans. Reasons for ESOs differ, but generally, employers use these plans to woo prospective workers, increase staff loyalty, and improve employee performance. Additionally, stock options help small businesses compete with larger organizations. Learn what stock options are and how to use them as a business strategy.

What are employee stock options, and how do they work?

Employee stock options are part of a benefits plan and equity compensation. It gives staff the right to purchase shares at a set price (the exercise or grant price) but doesn’t require them to do so. Both parties sign a contract that explains the terms, such as how many shares they can buy and when.

Companies can offer stock options to all employees or just a few. In addition, you can award shares outright or based on performance. Unlike employee-owned companies, “ESOs do not include any dividend or voting rights,” according to Investopedia.

Agreements may list a vesting period, describing when employees can exercise their options (buy shares). You can let individuals purchase the total amount of stock once they’re vested or spread out purchases over a few years. Business Insider stated, “A typical options vesting package spans four years with a one-year cliff. A one-year cliff means you will not get any shares vested until the first anniversary of your start date.” Employees who leave before the one-year cliff lose the right to buy shares.

[Read more: Offering Employee Benefits? Here’s How to Afford Them]

Business Insider stated, “A typical options vesting package spans four years with a one-year cliff. A one-year cliff means you will not get any shares vested until the first anniversary of your start date.” Employees who leave before the one-year cliff lose the right to buy shares.

Types of stock options for small businesses

Before creating a contract, you must decide how to offer stock options. Each solution affects your company and employee taxes. Eligibility requirements also differ among the choices. A financial and tax advisor can help you understand the pros and cons of each method. It’s crucial to consider the impact on your small business and how desirable it makes your benefits and compensation package to prospective employees.

Four types of stock options include:

  • Qualified small business stock (QSBS): Also called founder shares or Section 1202 stock, QSBS offers substantial tax benefits when held for more than five years. C corporations with $50 million or fewer assets can use this form of stock option.
  • Unexercised incentive stock options (ISO): Leaders typically offer ISOs (also known as statutory or qualified options) to upper management and key staff. These can provide tax benefits, as the IRS may treat profits as long-term capital gains.
  • Unexercised non-qualified stock options (NQSO): Owners generally offer independent contractors, board members, and non-executive staff NQSO, also called non-statutory stock options or NSOs. These are taxed as ordinary income.
  • Restricted stock units (RSU): While not technically stock options, firms may offer RSU as part of an equity compensation strategy. Employers give RSUs to workers, and employees pay tax when the RSUs vest.

Advantages and drawbacks of offering ESOs

According to the National Center for Employee Ownership (NCEO), 22% of workers own shares of stock in the business they currently work at “either directly or through some type of retirement or stock plan.” Companies use ESOs to incentivize workers to stay long-term and contribute toward business growth. As an organization grows, so may the stock price, allowing employees to realize a significant profit. ESOs are cost-effective for startups and small businesses because companies can pay new employees less cash up front and instead offer them the possibility of future value.

However, ESOs aren’t a good solution for every business. Each time you give employees stock options, you’re giving away company equity, reducing your shares in the organization. It can also be challenging for private businesses to value stock options and create a market for selling shares. To protect your company and realize the benefits of offering stock options, you should work with financial and tax advisors and complete a thorough business valuation.

[Read more: What You Need to Know About Qualified vs. Non-Qualified Benefit Plans]

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

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Published October 18, 2022