Employee Stock Options (ESO); Explained

Employee stock options (ESO) are a form of compensation that corporations give to their executives and senior employees. A stock option granted to specified employees of a company. ESOs carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price. An employee stock option is slightly different from a regular exchange-traded option because it is not generally traded on an exchange, and there is no put component. Furthermore, employees typically must wait a specified vesting period before being allowed to exercise the option.
Unlike salary or bonuses, the value of a stock option depends on the price of the company’s stock going up. The idea is that a stock option thus serves as an incentive to the employees to work hard to ensure the company performs well.

Identification
An ESO gives the holder the right to buy shares of the company stock at a stated price called the “strike price.” Usually, the company requires the employee to wait a minimum holding time before she may exercise the option after it is issued. From then until the expiration date, the employee can exercise the option at any time. If company stock appreciates, the employee can use the option to buy shares at the lower strike price and then resell them at the market price, keeping the difference.

Types
There are two basic kinds of employee stock options.
Statutory options (also called “qualified” or “incentive options”) allow the holder to get capital gains tax rates on profits derived from exercising the option, provided certain rules are followed.
Non-qualified or non-statutory options cannot get this tax break, but they allow more flexibility for the option holder in other respects.

Reload Options
Some non-qualified stock options have a “reload” provision in the contract. Suppose you have an employee stock option for shares with a strike price of $20 and the market price is now $30/share, but the option does not expire for another year or so. You can exercise the option and avoid the chance the stock might decline, or you can hold the option in hopes the stock will appreciate further. With a reload, you get to do both. When a reload option is exercised, the company issues a new option with the same expiration date, but with the current market price as the new strike price. You can secure gains made to date and still collect the profit from any future increases in the stock’s value by exercising the reloaded option again later on.