Stock options are typically granted as part of an employee’s compensation package. Employers offer the right to buy a specific number of shares at a fixed price (the exercise price), which is usually set at the market value of the shares on the grant date. However, employees can’t immediately exercise these options; they must wait until the options vest. Vesting periods vary but are often spread out over several years to encourage employees to remain with the company long term. Once the options vest, employees have the right to exercise them at the strike price, regardless of the current market value.

When an employee exercises their stock options, they purchase company shares at the predetermined strike price. If the current market value of the shares is higher than the exercise price, the employee can benefit by buying the shares at a discount and selling them at a higher price. The difference between the strike price and the market value is the employee's gain, commonly known as the “spread.” However, employees can also choose to hold onto the shares if they believe the stock price will increase further in the future. Holding the shares provides the potential for greater gains, though it also carries the risk of market volatility.

One of the key reasons companies offer stock options is to attract and retain top talent. Stock options provide a long-term incentive for employees to stay with the company, as they are typically structured with a vesting period. The potential for financial gain from exercising stock options can be a significant motivator for employees, especially when they see the value of the company increase over time.

Stock options encourage employees to think like shareholders. Since the value of stock options depends on the company’s stock performance, employees are more likely to focus on activities that drive company growth, profitability, and innovation. This alignment of interests fosters a sense of ownership and commitment to the company’s success. For employers, this can lead to increased productivity and engagement, as employees are motivated to contribute to the long-term success of the business, knowing their financial interests are tied to the company’s performance.

For startups and growing companies, offering stock options can be an effective way to conserve cash while still offering competitive compensation. Instead of high salaries, companies can offer equity-based incentives, allowing them to save money in the short term while providing the potential for future rewards. By offering stock options, companies can attract and retain talent without the need for large cash outlays, particularly during the early stages of growth when cash flow might be limited.

While stock options can be a powerful tool, administering them is complex. Employers must ensure that vesting schedules, tax implications, and stock option agreements are clearly communicated to employees. Managing stock option plans requires collaboration between HR, finance, and legal departments to ensure compliance with regulatory requirements and company policies. In addition, companies must track the status of each employee’s stock options, including the number of options granted, vested, and exercised, as well as the expiration dates. This administrative burden can be significant, particularly for companies with large stock option programs.

One potential downside of offering stock options is the dilution of ownership. As employees exercise their options and purchase shares, the total number of shares outstanding increases, reducing the ownership percentage of existing shareholders. For early investors or company founders, this dilution can be a concern. Employers must carefully balance the number of stock options they grant with the potential impact on overall equity. Proper planning and communication with shareholders are essential to avoid conflicts related to ownership dilution.

Stock options come with significant tax implications for both employees and employers. Employees who exercise stock options may face taxes based on the difference between the exercise price and the market value of the shares at the time of exercise. The type of stock option (ISO or NSO) affects how this income is taxed. For employers, offering stock options can have tax benefits, such as deductions for compensation expenses. However, it’s essential to stay compliant with tax laws and reporting requirements to avoid legal and financial penalties.