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Public and private companies may offer forms of stock compensation, including employee stock option (ESO) plans. The reasons for ESOs vary, but generally employers use these plans to attract future workers, increase staff loyalty, and improve employee performance. Additionally, stock options help small businesses compete with larger companies. Learn what stock options are and how to use them as a business strategy.
What are employee stock options? Also how does it work?
Employee stock options are part of benefit plans and stock compensation. This entitles employees to purchase shares at a set price (exercise or grant price), but they are not required to do so. Both parties sign an agreement that describes the terms and conditions, including the number of shares that can be purchased and when.
Companies can offer stock options to all employees or to a small number of employees. Additionally, shares can be awarded outright or based on performance. According to Investopedia, unlike employee-owned companies, “ESOs do not include dividends or voting rights.”
The contract may include a vesting period that explains when the employee can exercise the option (ie buy the stock). Once vested, you can have individuals purchase the full amount of the shares or spread the purchase over several years. Business Insider said: A one-year cliff means that the shares will not vest until after his one-year anniversary from the start date. ” Employees who retire before the one-year cliff will lose their right to buy shares.
[Read more: Offering Employee Benefits? Here’s How to Afford Them]
Business Insider said: A one-year cliff means that the shares will not vest until after his one-year anniversary from the start date. ” Employees who retire before the one-year cliff will lose their right to buy shares.
Types of stock options for small businesses
Before creating a contract, you need to decide how you will offer stock options. Each solution has tax implications for the company and employees. Eligibility requirements also vary by choice. A financial and tax advisor can help you understand the pros and cons of each method. It’s important to consider the impact on small businesses and how desirable benefits and compensation packages it will make to future employees.
There are four types of stock options:
- Qualifying Small Business Stocks (QSBS): QSBS, also known as founding shares or Section 1202 shares, offer substantial tax benefits when held for five years or more. C companies with less than $50 million in assets can use this form of stock option.
- Outstanding Incentive Stock Options (ISO): Leaders typically provide ISOs (also known as statutory or accredited options) to senior management and key staff. These can offer tax benefits as the IRS may treat the gains as long-term capital gains.
- Outstanding Non-Qualified Stock Options (NQSO): Owners typically offer independent contractors, board members, and non-executive staff NQSOs, also known as nonstatutory stock options or NSOs. These are taxed as ordinary income.
- Restricted Stock Units (RSU): Although technically not stock options, companies may offer RSUs as part of a stock compensation strategy. The employer gives her RSUs to the worker, and the employee pays taxes when her RSUs vest.
Advantages and disadvantages of providing ESO
According to the National Center for Employee Ownership (NCEO), 22% of workers own stock in the company they work for “either directly or through some form of retirement or stock plan.” Companies use ESO to motivate employees to stay longer and contribute to business growth. As the organization grows, so does the stock price, and employees can reap significant benefits. ESOs are cost-effective for start-ups and small businesses. This is because companies will have less upfront cash to pay new employees, in return providing potential for future value.
However, ESO is not the right solution for every business. Every time you give an employee his stock options, you are transferring shares in the company, reducing your stake within the organization. It can also be difficult for private companies to value stock options and create a market for selling shares. To protect your company and realize the benefits of stock option offerings, you should work with your financial and tax advisors to complete a thorough business evaluation.
[Read more: What You Need to Know About Qualified vs. Non-Qualified Benefit Plans]
CO— aims to draw inspiration from leading and respected professionals. However, before making any business decision, you should consult a professional who can advise you based on your individual circumstances.
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Published October 18, 2022
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