Employee Stock Options: Types & How They Work

May 2, 2025
9 min read
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Companies stand out in the job market by adding attractive perks to their compensation packages. Employee stock options (ESOs) are proven to increase the appeal of a compensation and benefits plan, helping businesses attract anageand retain a high-quality workforce.
ESOs are a form of equity compensation that incentivizes employees and stakeholders to contribute to the company’s growth and success. It gives them the opportunity to own a piece of the company and profit if its value increases over time. This guide explains how ESOs work and their advantages for both employers and employees.

What are stock options for employees?

ESOs give employees the right to purchase a specified number of company shares at a preestablished, fair market price. This rate is known as the strike price, grant price, or exercise price.
Stock options aren’t company shares. They are a type of call option that gives employees the right, but not the obligation to purchase stock. Employees don’t have to exercise their options immediately. They can wait for a designated period, often hoping the stock’s market value will rise. If it does, they can buy the shares at the original strike price and either sell it for a profit or hold them in case the value continues ot increase. Alternatively, if the stock price doesn’t rise above the strike price, employees can choose to let the options expire without purchasing any shares at all. 
While ESOs are available at public companies, they are especially common at startups and fast-growing private companies, where they serve as a key tool to recruit and retain top-tier workers. When the venture goes public, employees can still exercise stock options at the original strike price — even if the publicly available price is much higher.
Employers must outline and clarify the terms of stock options in their compensation and benefits agreements.

How do employee stock options work?

All types of employee stock options follow a four-step lifecycle:
  1. Grant. First, the employer establishes the strike price and extends the option grant to employees. This grant lays out the price, number of shares, and vesting schedule. Typically, the strike price matches the stock market’s assessment of fair market value at the time the corporation grants the option.
  2. Vesting. Employees must wait for a mandated time frame, known as the vesting period, before they can exercise stock options. The vesting schedule may also require employees to meet predefined performance goals.
  3. Exercise. After the vesting period, employees can freely buy shares at the strike price. Depending on the option type, they may be taxed on their earnings. 
  4. Sale. Employees can sell their stock immediately after exercising or hold it. Profits are subject to capital gains taxation. 

Types of stock options

Employers can offer one of two types of stock options as part of a compensation plan: incentive stock options (ISOs) or nonqualified stock options (NSOs).

Incentive stock options

ISOs, also called statutory or qualified options, are typically only available to a company’s employees. If held for the required period — typically 10 years — these options receive preferential tax treatment from the IRS, with profit treated as long-term capital gains. 
However, ISOs come with limitations such as grant and strike price limits, so employees should review their terms before exercising the option to buy. ISO earnings may also be subject to the alternative minimum tax (AMT), depending on how long the employee holds the exercised stock. ISO holders should consult an accountant to determine the appropriate course of action. 

Nonqualified stock options

Companies can grant NSOs to employees, board members, advisors, and consultants. Unlike Incentive Stock Options (ISOs), NSOs don’t qualify for special tax treatment, which means they’re subject to taxation at two separate points.
First, when the option is exercised, the difference between the strike price and the fair market value (known as the bargain element) is treated as ordinary income and taxed accordingly.
Then, when the shares are eventually sold, the gain or loss from the sale—calculated from the fair market value at the time of exercise—is subject to capital gains tax. The rate depends on how long the shares were held after exercise: short-term if sold within a year, and long-term if held for more than a year.

Benefits of stock options

Stock options deliver significant advantages for employers and employees.

For employees

The benefits of stock options to employees are wide-ranging and diverse. Here’s how they supplement a compensation package:
  • Financial gain. Employees can enjoy profits if they exercise their options and sell the stock above the strike price.
  • Tax advantages. ISOs can grant tax savings to employees if they sell their shares at least one year after exercising the option and two years after the grant is issued.
  • Morale. ESOs connect employee compensation to company success, helping them see the value of their contributions.
  • Motivation. ESOs motivate employees to support the company’s success to secure greater returns. 

For employers

Businesses that offer equity compensation enjoy several advantages. ESOs promote organizational growth in the following areas:
  • Recruitment. ESOs are an important recruitment tool, helping the company stand out and attract top talent by conveying a commitment to people’s financial health. Studies show that 73% of financially stressed employees would be attracted to a new employer that cares more about their financial well-being, compared to 54% of non-financially stressed employees.
  • Business performance. ESOs encourage an ownership mindset by giving employees a stake in the company’s success. Workers have a direct incentive to help the organization grow and succeed.
  • Employee engagement. ESOs provide financial security and encourage greater job satisfaction, fostering a productive work environment.
  • Worker retention. Stock options reduce employee turnover, since workers must stay with the company to complete the vesting schedule and take advantage of their stock options.

Challenges of offering ESOs to employees

Although ESOs are an attractive benefit, they may not always perform as expected. Employers should consider these potential obstacles:
  • Value loss. A stock option doesn’t guarantee a profit. If the company doesn’t grow, neither will the share value. 
  • Equity dilution. If many holders exercise their options simultaneously, they may dilute shareholder equity.
  • Accounting and tax burdens. ESOs bring complex financial implications for employers, including strict regulations and caps, as well as the requirement to issue tax forms to employees.
  • Complex administration. Management and administration can be labor intensive. The company must track and report ownership changes, update policies, communicate with stakeholders, and maintain legal compliance.
  • Benefits end after vesting. Although employees can hold onto stock after the vesting period, they may be tempted to sell, eliminating their incentive to contribute to company value. Employers may need to offer additional stock options to keep them engaged and retained.

Help support financial wellness beyond stock options

ESO are a compelling addition to a compensation plan, offering the potential for long-term financial security to employees. However, equity is just one piece of total rewards — and it’s not something every employee receives or benefits from equally. To build a more inclusive and immediate impact, employers should also consider offering financial wellness benefits that support all employees.
Fortunately, there are financial wellness perks employers can easily offer that provide such value to employees. EarnIn helps reduce financial stress by providing employees access to simple, effective tools, such as Credit Monitoring,1 Balance Shield,2 which helps protect against overdrafts, and Cash Out, our Earned Wage Access (EWA) tool that allows employees to access a portion of their earned wages – up to $150 per day, with a max of $750 between pay days.3 Employees can receive their earnings the same day they work, starting at just $2.99 per transfer.4
Best of all, EarnIn requires no payroll or time and attendance integration and comes at no cost to employers. Since using EarnIn, 58% of users say they’re able to budget more effectively.5 
Request a demo today to learn how EarnIn can help support employee financial stability and contribute to an attractive compensation package.
Please note, the material collected in this post is for informational purposes only and is not intended to be relied upon as or construed as advice regarding any specific circumstances. Nor is it an endorsement of any organization or services.
EarnIn is a financial technology company, not a bank. Banking services are provided by our bank partners on certain products other than Cash Out.
1
Your VantageScore 3.0 from Experian® indicates your credit risk level and is not used by all lenders, so don't be surprised if your lender uses a score that's different from your VantageScore 3.0. Learn more.
2
Balance Shield provides free alerts when your bank account balance drops below the threshold you set in your EarnIn account. You can also enable automatic transfers ($100/day -subject to your available earnings- with a limit of $750/pay period), if your bank account balance falls below your set  threshold. If your available earnings are insufficient to transfer the $100, the transfer will not be completed.You choose the speed of these automatic transfers. Standard speed is available at no cost and the transfer typically takes 1-2 business days. Lightning Speed is available for a fee [see Lightning Speed Fee Table] and the transfer typically takes less than 30 minutes. You will also have the option to set a tip for automatic transfers. Tips are optional and can be $0; however, if you choose to set a tip, it will be applied to each Balance Shield transfer. Whether you tip, how much, and how often you tip does not impact the quality and availability of services. You can cancel the alerts and/or transfers at any time in your EarnIn account settings. See the Cash Out User Agreement  for more details. While Balance Shield can help you avoid overdrafts, it does not guarantee protection from third-party fees, and its effectiveness depends on your usage and bank activity.
3
A pay period is the time between your paychecks, such as weekly, biweekly, or monthly. EarnIn determines your daily and pay period limits (“Daily Max” and “Pay Period Max”) based on your income and financial risk factors as outlined in the Cash Out Maxes section of our Cash Out User Agreement. EarnIn reserves the right to adjust the Daily Max and Pay Period Max at its discretion. Your actual Daily Max will be displayed in your EarnIn account before each Cash Out.
EarnIn does not charge interest on Cash Outs or mandatory fees for standard transfers, which usually take 1–2 business days. For faster transfers, you can choose the Lightning Speed option and pay a fee to receive funds within 30 minutes. Lightning Speed may not be available at all times and/or to all customers. Restrictions and terms apply; see the Lightning Speed Fee Table and Cash Out User Agreement for details and eligibility requirements. Tips are optional and do not affect the quality or availability of services.
4
Lightning Speed is an optional service that allows you to expedite the transfer of funds for a fee. Depending on the product, the fee may be charged by EarnIn or its banking partner. Lightning Speed may not be available in all states and/or to all customers. Restrictions and terms apply. See the Lightning Speed Fee Table for details.
5
Based on EarnIn Survey of 1654 EarnIn Community Members 10/12/2023 - 11/15/2023.