So, you’ve just gone for an interview for a position at a startup, SME or tech company, and they’re offering you the chance to receive employee stock options as part of your package.
Owning shares in the company you work at sounds nice on paper, and it’s easy to see how that would motivate you to work harder. But what does it really mean?
How do employee stock options (ESOPs) work?
As you probably already know, stocks are shares in a company’s ownership. So, when a company offers you stock options, it means you have the chance to own part of the company, however small. If the company becomes more successful, your share value can rise. Likewise, if it tanks, so do your shares.
ESOPs, however, are not shares. They are unvested stock options. This is a promise to offer you the right to purchase a certain amount of shares, usually upon fulfilling certain conditions, such as working for the company for a certain amount of time. When you fulfil these conditions, you will finally be able to exercise the option and purchase the stocks — that is, they go from unvested to vested.
While owning stock in the company sounds good, beware that it usually comes at the expense of salary. Some companies might offer a choice between a higher salary without stock options, or a lower salary with stock options. It’s a gamble — if you are working for the next Google, picking the stock options might make you rich, but the reverse is true if the company does not do well.
Another thing to look out for is the vesting schedule. If the company expects you to work there for many years in order to vest the ESOPs, it might not be worth your while. When you quit, you lose your rights to any unvested ESOPs.
Other factors to take note of include the exercise price you’ll be offered, which might or might not be lower than the market price of the stocks, as well as what will happen if the company has an IPO or gets bought over.
How are they different from Employee Share Ownership (ESOWs)?
Employee Share Ownership (ESOW) is another form of employee compensation that looks suspiciously similar to ESOPs.
The main difference is that, instead of stock options that must be exercised, you get the stocks upfront. The stocks can, however, be distributed according to a vesting schedule, just as with ESOPs.
With ESOPs, you need to exercise your stock options when the conditions in the vesting schedule have been fulfilled. With ESOWs, you don’t — the stocks are just automatically handed to you.
Are employee stock options taxable?
Yes, they are.
Since ESOPs are considered part of your compensation package, you must pay income tax on any gains or profits arising from the exercise of employee stock options.
How and when will you be taxed for ESOPs and ESOWs?
How do you calculate your gains or profits for tax purposes? Here’s the formula:
Open market price of share on the date you exercised ESOP – Price you paid for the shares in exercising your stock option = Gains / profits for tax purposes
If there is no vesting period (ie the stock option is granted to you immediately), you will pay taxes on gains in the year the shares were granted rather than the date the ESOP was exercised.
There is one exception — if there is a restriction on selling the stocks, you only get taxed in the year when you are finally allowed to sell them, vesting period or no vesting period.
The same rules apply for ESOWs, except that instead of the date the stock option was exercised, you will pay taxes on the date you were given the stocks or the date the stocks vested.
Examples of employee stock options globally: Google and Salesforce
Stock options are a popular way for startups and tech companies to save money, as it enables them to pay lower salaries upfront. The employees in turn get to reap the benefits if the company does well later.
Google now gives selected employees Google Stock Units. These are a kind of Restricted Stock Unit, which is a popular form of compensation doled out by big, publicly-listed tech companies like Meta and Amazon.
Unlike regular ESOPs, Google Stock Unit options are free to exercise. They are doled out according to a vesting schedule. Google tends to offer a schedule that has the shares vesting every quarter after one year of service.
Another company that offers stock options is Salesforce, the company behind a well-known customer relationship management software that even Amazon uses.
Like Google, they offer Restricted Stock Units. Employees are given the option to trade two per cent to 15 per cent of their salary, bonuses or commissions for stocks, which they can purchase at a 15 per cent discount off the market value. It’s up to the employee how long they wish to hold on to the shares before selling them.
This article was first published in MoneySmart.