When starting a company from scratch, it’s probably hard to always compete with big salaries and corporate perks, both of which are important for employee satisfaction and retention. What you can offer your employees, though, is a real share in something that has the potential to grow; an employee stock option plan (ESOP). This guide will walk you through different types of ESOPs and what benefits they provide.
Understanding Employee Stock Option Plans (ESOPs)
Most companies often include stock options in job offers as part of the compensation package. These stock options are usually part of an Employee Stock Option Plan (ESOP). They’re employee benefit plans through which employers can purchase stocks in the company. Instead of giving shares outright, the company offers the option to purchase stock later, usually after a vesting period. If the company does well and the share price rises above the exercise price, employees can buy at the lower price and sell at market value, earning a meaningful profit. It is then the employee’s choice to either cash out or hold onto the stocks.
Kinds of ESOPs
It’s essential to understand the type of stock options you want to offer employees, as each comes with its own benefits and tax consequences. The two main categories of ESOPs are:
1. Incentive Stock Options (ISOs)
You can reserve these ESOPs for key employees, like your early hires, executives, or core team members. They’re usually called “qualified” or “statutory” stock options, mainly because they meet certain IRS requirements, like a minimum two-year vesting period and holding the share for at least one year after exercising, which makes them more favorable tax-wise.
Employees get the option to buy company shares at a set price, usually the market value on the day the option is granted. However, they can’t just flip the stock right away. There’s typically a vesting period, and then, once they exercise their options and buy the shares, they need to hold onto them for more than a year to get the full tax benefit.
This means employees can buy company shares at a lower, pre-set price, and if they hold onto those shares for at least two years before selling, they’ll likely only pay long-term capital gains tax instead of the higher short-term rate. That can add to significant tax savings, especially if the company’s value has grown significantly during that time.
2. Non-Qualified Stock Options (NSOs)
NSOs, on the other hand, have a more flexible nature and are known as “non-statutory” stock options. In addition to employees, you can offer this to advisors, board members, consultants, or even vendors. They’re easier to manage but don’t have the same tax perks as ISOs.
When someone exercises their NSOs, the difference between that price and the current market value is immediately taxed as ordinary income. Then, if they sell those shares later at a profit, they’re taxed again on the gain. NSOs can get taxed twice and don’t come with the same favorable treatment as ISOs.
Endnote
A company is only as strong as the team behind it, and showing them equity is a way to reward their contributions. Companies provide stock option plans to retain their employees. But for these plans to work, you need to understand the different kinds and how they align with your company’s goals.
Photo by Austin Distel; Unsplash
