Employee Stock Options is a contract between two parties namely the buyer or the holder of the stock and the seller or the writer, the buyer buys/purchases the rights but not the obligation to buy/sell the shares of the stock at a price which has been predetermined. The purchase need to be made within a specific period of time. Usual time period for stocks is 4-5 yrs.
It is one of the ways in which a company provides the employee compensation. It is referred as Employee stock option. Example, after landing in a job organizations employees are given some stocks as part of their compensation, employee becomes the owner of that stock for using the same he should know the worth of the stock. Employee stock option is also an agreement which gives an outline including the rules and policies of using the stock plan. Strike price or exercise price is the price at which the employees can purchase the stock. Employees have to wait for a specific period of time before they can use the stock, after the lapse of that period the stock option is said to be vested. Once the option is vested employees are able to exercise the option. After the period gets lapsed stock option has no value.
There are two broad categories of stock options mainly:
(a) Incentive Stock Option, through which the employee defers the tax till the time the share options are sold. There isn’t any deduction of tax on such options.
(b) Nonqualified Stock Options, wherein the employee has to pay income tax on the difference between the value of the stock and amount paid for the same.
Stock options work best for small companies where the prospect of growth is high and also in case when the company plans to provide its employees with some kind of ownership.