Many corporations use employee stock options (ESO) to motivate and reward senior employees. For an employee stock option to have any value, the company's stock must appreciate in value, so it's in the employees' interest to do their best. The practice of awarding ESOs is sometimes criticized as an "off balance sheet" (hidden) expense that is used to excess. Employee stock options are often the largest portion of an executive compensation package and may earn an individual hundreds of thousands or millions of dollars.
Identification
An employee stock option is similar to the call stock options traded in markets like the American Stock Exchange or Chicago Board of Options Exchange. The option grants the right to purchase shares of stock at a guaranteed price referred to as the strike price. There is no obligation to exercise the stock option, but the employee can do so on or before the expiration date (called the expiry). If the stock goes up in price, the employee can exercise the option by purchasing the stock at the strike price, then sell at the market price, keeping the difference. ESOs are not negotiable (they can't be traded on exchanges) and come in several forms.
Basic ESOs
The basic form of an ESO is often called non-statutory stock option to distinguish it from an incentive stock option (see below). The option contract typically stipulates the employee may not exercise the option for a period of time from one to three years. From that point until the expiry the employee can exercise the option at any time. Profits from non-statutory stock options are not eligible for capital gains tax rates. Companies often prefer them because the corporation gets a tax break.
Incentive Stock Options
An ISO (incentive stock option) allows employees to take capital gains on any profits from the options. To qualify, the employee must hold the option for at least one year after it is issued before exercising it. Then the stock itself must be held for one additional year. An employee does have to accept some risk by holding the stock, since the stock might drop in price during the year it is held to qualify for capital gains taxes. Corporations often prefer not to use ISOs because they don't get the tax advantages they receive with non-statutory stock options.
Reload Options
"Reload" is a term used to describe a special feature of some employee stock option contracts. With a reload option, the employee can choose to exercise the option if the stock has appreciated, taking the profit up to that time. Then the employee is issued a new option with the market price as a new strike price and the same expiration date. If the stock continues to go up in price the employee can exercise the option again, making more money.
Exercise
In theory, an employee must pay the strike price to exercise the option. In practice, this isn't necessary (except for ISOs). Instead, the employee delivers the option to his/her broker, who then "loans" the funds necessary in exchange for a small fee. The broker immediately sells the stock at the market price. The broker gets his money back and the difference between the strike price and the market price is deposited in the employee's brokerage account.
