Knowing the difference between stock options and ESOPs will help you evaluate them and decide what they are really worth as part of your compensation package.
How Do Stock Options Work?
Stock options are routinely used to attract potential employees and retain existing employees. Stock options are not stocks but are instead the right to buy the stock at an agreed price and date.
When you exercise the option, you will have to pay the option’s strike price to receive the stock. If you don’t exercise the options, they will expire, and you will no longer be able to buy the shares.
You will not be able to exercise options until after the “vesting period” ends. A vesting period is a specified amount of time you must be with the company. A typical vesting schedule gives you options after one year and then every year for four years. The longer you stay, the more options you receive.
Employees usually get a discount on the stock’s market price. There would be no point in exercising an option if you could buy the shares for less on the open market.
How Do ESOPs Work?
An employee stock ownership plan (ESOP) gives employees the right to own company stock.
The plan gives shares of stock to employees. You do not have to purchase the shares. The shares remain in what is called “trust” in your name.
Shares are vested over time. You do not buy or own the shares directly while you are still employed by the company. If you leave the job, the plan will distribute the shares into your account.
Differences Between Stock Options and ESOPs
It is important for you to know which type of plan your potential employer offers. The differences are significant.
|You can buy stock in the company at a discounted price lower than the market value||The company gives you stock–you don’t have to buy it.|
|You will pay tax on any profit made by selling the shares.*||You will not pay tax until the shares are transferred to your account.*|
|You can buy and sell stock when you are “vested”, usually meaning after one or two years with the company.||You do not have access to your stocks until you resign or retire.|
Similarities Between Stock Options and ESOPs
Both types of plans come from employers who want to keep people in the company long-term. Here is what they have in common.
- Owning Part of the Company: With either approach, you stand to benefit from the company’s success.
- Benefitting From the Long Term: These plans work best when you let them grow over time. Though you can sell the stock you get when you exercise options, short-term trading is risky. Letting it ride may be your best bet. And, of course, you cannot sell your stock from an employee stock ownership plan.
In either case, it’s best to treat these plans as a bonus. A lot can happen after you take a job. You may decide to leave before the vesting period is up. The company’s stock may turn out to be less valuable than you expected.
That doesn’t mean these plans are worthless. They can be worth a great deal. You still shouldn’t consider them a primary factor in a decision to take a job because of the inherent uncertainties they pose.
How to Evaluate Stock Options vs. ESOPs
If you don’t invest in stocks already, owning shares of a company can sound exciting. Don’t get too carried away.
Owning stock can be lucrative, but it’s not guaranteed to be lucrative. It’s a bet on both the future of the company and your desire to stay with the company for an extended period.
Consider these factors when evaluating stock options and ESOPs.
1. Is Your Company Public or Private?
If your company’s shares are trading on a stock exchange, it’s a public company. That means you know exactly what the shares are worth at any given time, and you know how their value has changed over time.
That also means that you can sell your shares at any time after you take possession of them.
If your company is privately held, it may be more difficult to assign a value to the shares. There’s also no assurance that there will ever be a public market for the shares you get. Unless there are clear signs that your company intends to go public, you can’t assume that the shares will ever be negotiable.
2. Is the Company Viable?
If you’re going to work for a startup company, it’s easy to get carried away by visions of what your stock could be worth if your company turns out to be the next Google, Facebook, or Tesla.
Remember that many startups fail. In fact, 90% fail. Your stocks will be worthless if the business doesn’t make it.
If the company is already established, do a little research. Has it been losing sales lately? Have profits decreased? How is it doing against the competition?
Private companies (ones that don’t sell stock to the public) don’t publish such information, but you can find online services that can help you calculate the valuation. Public companies publish the information in quarterly and annual reports to the SEC, so they are easier to evaluate.
3. Is the Company Stock Part Of Your Salary?
If a prospective employer tries to use stock options or a stock ownership plan to persuade you to take a lower salary than you otherwise would, be careful. That’s especially true if the company is privately held or a startup.
Stocks are not guaranteed income. They can lose value. There may never be a market for private company shares. Don’t let anyone tell you that stocks always go up in value. That is a general statement that may not apply to your stock.
Note that private company stock options can be tough to value. The worth of private company options depends on the value of the company. This requires comparing it to a similar private company. But of course, that value will change over time, so you are still left guessing. There is no solid basis for assigning a value to them when negotiating your salary.
Count stocks as a possibility to make money in the long term. You won’t be buying groceries with them.
4. Can You Afford to Exercise Stock Options
Stock options sound like a great perk, but you still have to pay to exercise them. Many employees end up leaving stock options on the table because they can’t afford the price.
There are companies that will help you finance stock option acquisitions, but you will have to share the proceeds of any eventual sale with them.
5. What Are the Tax Costs?
Be sure and look at taxes when evaluating stock options vs. employee ownership plans.
Taxes for Stock Options
A stock option is merely permission to buy stock. An option has no dollar value. You don’t pay tax on a stock option.
If you choose to exercise your options, you will pay tax on your profits and dividends. Profits from the sale of stock may be treated as capital gains or as ordinary income, depending on how long you hold them.
- You pay capital gains tax on profits on stocks you hold for at least one year before you sell. You don’t owe any tax if you don’t sell.
- If you sell stocks after holding them for less than one year, your earnings will be taxed as regular income.
- Dividends will be taxed as regular income in the year they are received.
If you don’t earn a profit on the stock sale, you will not pay tax.
Taxes on Employee Stock Ownership Plans
You don’t pay tax when your employer awards you stock because the stock is held by your employer for you. You only pay tax when you start receiving distributions from your stock account. This is available when you leave the company or retire. Usually, you receive distributions over a five-year period.
You can choose to roll over your stocks into an IRA. You won’t pay tax at the time of the rollover. You will pay tax on distributions from the IRA.
How to Choose
Few employers offer all the choices we have looked at, but you may be considering two employers, one that offers stock options and one that offers a stock ownership plan. Here are some criteria to consider.
Stock options give you the opportunity to profit relatively soon. You can sell when you want (if the company is public), meaning you don’t have to wait for retirement or resignation. You will spend your own money to buy the stocks, and you will pay taxes on your gains as they occur. Your stock shares sell at a discount so you have profit the moment you buy them. That is, the market price will be higher than the price you paid.
The Big Idea: You can make (or lose) money each year.
In an employee stock ownership plan, you don’t have to buy the stock. It is a bonus. But you also can’t get it right away. Only when you leave or retire can you get distributions. You don’t pay taxes until that time.
The Big Idea: Stocks from employer stock ownership plans are for the long, long term. You will not get control of the stock until you leave the company or retire.
In practice, employee ownership plans are most often offered to executives, whereas rank-and-file workers tend to be offered stock options.
Either way, there’s a huge difference between being offered stock-based compensation at a public company and a private company. Private company shares have to be considered a much more speculative form of reward.
Know Your Acronyms
In investing. you will find many acronyms. It is important to understand them.
Here we have used “ESOP” to refer to stock ownership plans, where you receive free stock from the company.
Unfortunately, some people use “ESOP” to mean “employee stock option plan.” which, of course, refers to plain old stock options.
If an employer mentions an ESOP, clarify whether they are talking about stock options or stock grants from an employer ownership plan. They are quite different.
Can You Lose Money?
You can’t lose money in an employee ownership plan. Because the stock is a bonus, you didn’t pay anything. You might see the stock go down in value, but that just means you got less of a bonus than you anticipated. You didn’t put any money in, so you can’t lose money.
If you exercise stock options, you can lose money. That’s because you have to buy the stock out-of-pocket. If your stock drops in value, you would lose money if you sold it.