Employee Stock Option (ESO)

An employee stock option (ESO) is a contract between an employer and an employee that gives the employee the right to purchase a certain number of shares of the employer's stock at a specified price (the exercise price) within a certain period of time (the exercise period). ESOs are often used as a form of employee compensation, and they can be a valuable tool for companies to attract and retain top talent.

There are two main types of ESOs: incentive stock options (ISOs) and nonqualified stock options (NQSOs). ISOs are granted to employees who meet certain performance criteria, and they are taxed at the favorable capital gains rate when they are exercised. NQSOs are not subject to any performance criteria, and they are taxed as ordinary income when they are exercised.

The exercise price of an ESO is typically set at the fair market value of the stock on the date the option is granted. However, the exercise price can be set at a lower price (a discount) or a higher price (a premium) than the fair market value. The difference between the exercise price and the fair market value of the stock at the time of exercise is called the "option spread."

The exercise period of an ESO is typically 10 years, but it can be shorter or longer. If an employee exercises an ESO before the end of the exercise period, they will have to pay income taxes on the difference between the exercise price and the fair market value of the stock at the time of exercise. If an employee exercises an ESO after the end of the exercise period, they will have to pay income taxes on the difference between the fair market value of the stock at the time of exercise and the stock's value on the date the option was granted.

ESOs can be a valuable tool for companies to attract and retain top talent. However, it is important to understand the tax implications of ESOs before granting them to employees.