Startup companies commonly include stock options in employee compensation packages. They are a great tool to incentivize strong employee performance by linking pay to performance. Employee stock option plans also align executives’ financial interests with shareholders’ interests.

What Are Stock Options?

An employee stock option grants the right, but not the obligation, to purchase a set number of shares of the company. The purchase takes place at an agreed upon price and date. The idea is that a growing company’s stock is likely to become more valuable in the future.

In the 1980s, executive compensation packages primarily consisted of cash from salaries and bonuses. Since the 2000s, this trend has reversed. A significant component of compensation packages today comes in the form of stock option grants. Stock options in executive pay packages have been a major factor contributing to the increase in average CEO pay in the United States. For instance, Thomas Rutledge, the CEO of Charter Communications, received $98 million of compensation in 2016, of which 80% stemmed from stock options.

Employee stock option (ESO) plans are drafted by the company’s board of directors. The stock options are usually subject to vesting schedules, meaning that you have to earn your shares over time. The ESO grants give the employee an exercisable call option if the company’s stock price rises above the exercise price, also known as the strike price. ESO agreements specify the time limit for exercising the option once vested, the exercise price per share, and other special restrictions.

Two Categories of Stock Options

There are two broad categories of stock options—the Incentive Stock Option (ISO) and the Non-Qualified Stock Option (NSO). The main distinction between ISOs and NSOs is in the tax treatment. ISOs are also subject to a number of restrictions that are not applicable to NSOs.

Incentive Stock Options

Incentive Stock Options are also commonly referred to as statutory or qualified options. Companies typically offer them only to key employees. They are subject to preferential tax treatment. ISOs are only subject to long-term capital gains tax upon their eventual sale. The exercise of an ISO does not carry any tax consequences.

Despite the tax advantages, ISOs come with a number of restrictions. Section 422 of the Internal Revenue Code outlines those restrictions. These stock options are non-transferable, except upon death of the stock option recipient. Additionally, employees may not treat more than $100,000 worth of exercisable options as ISOs in a given year. Any amount exceeding the $100,000 ISO limit receives NSO treatment for tax purposes.

Non-Qualified Stock Options

Non-Qualified Stock Options, also sometimes called non-statutory options, are awardable to individuals that are not employees of the company. Unlike ISOs, they do not get preferential tax treatment. The individual pays taxes on the difference between the grant price and the exercise price. The gains are classified as ordinary tax and thus subject to a higher taxation rate.

Other Types of Equity Compensation

Stock options are just one form of equity compensation a company can offer to their employees. Alternate types of equity compensation distributed to employees include restricted stock, stock appreciation rights (SARs), and phantom stock.

Restricted Stock

Sometimes, in lieu of stock options, a company will issue restricted stock. Stock options provide a right to buy a set number of shares on a fixed date in the future. In contrast, a company awards restricted shares outright. It is called restricted stock because the stock still must be earned, typically subject to a vesting schedule. Restricted stock grants come in two common forms—restricted stock units (RSUs) and restricted stock awards (RSAs).

RSUs are a promise made by a company to deliver shares on a future date. The recipient must satisfy certain vesting and performance conditions. RSAs are nearly identical to RSUs. The difference is that RSAs involve legally owning the shares on the same day the company grants them. The implication of owning RSA shares immediately is that vesting impacts only whether the company has a right to repurchase the shares. The repurchasing of shares by the company is permissible if certain conditions occur, often referred to as clawback provisions. Examples of clawback provisions include if an employee leaves the company early or if an employee leaves to work for a competitor.

Stock Appreciation Rights

Stock appreciation rights are another alternate type of equity compensation offered to employees. SARs enable companies to give their executives or employees a cash or stock bonus by increasing the value of a designated number of shares. They differ from stock options because the employee receives the right to appreciation in the price of the stock. But the employee does not receive actual shares of the stock itself. SARs provide the employee with a cash or stock payment based on the dollar amount of gain. The gain measured the value of the shares between the grant and exercise date. The tax treatment of SARs is nearly identical to that of NSOs.

Phantom Stock

Finally, phantom stock plans are highly similar to stock appreciation rights. The key distinction is that SARs provide a bonus payment based on the increase in the value of the shares. Phantom stock provides a bonus payment based on the value of the shares over a specified timeframe. Like with SARs, the future bonus from phantom stock is usually paid in the form of cash, not shares.

Stock Options One of Several Ways to Incentivize

Companies have a number of ways to incentivize their executives and employees to perform well through equity compensation plans. A given company’s decision to include different types of equity compensation such as ISOs, NSOs, restricted stock grants, SARs, and phantom stock is subject to many competing considerations.