An employee share option, also known as ESS or employee share scheme, is a scheme wherein employers or business owners offer employees options to acquire shares in the company.Employee share options are usually offered to key employees of the company. These are individuals whose expertise and dedication have become fundamental to the operations of the business. ESOPs are perfect for startups with limited capital. It’s a way for employers to show key employees that they appreciate and value their contribution. Employers will have to explain how many options are on offer, the cost of the shares, and when they’ll vest once an employee accepts an ESOP. By giving rewards, business owners can retain their best team members.Read on below to learn more about employee share options and the legalities surrounding them.How an Employee Share Option WorksIn ESOPs, employees can buy shares or get shares in the company they work for. Other terms used for employee share schemes are equity scheme, employee share purchase plan, and share options.Motivating, retaining, and attracting the best employees are the main goals of using share schemes. These are also steps taken by companies to align employees’ and shareholders’ interests. The different ways to pay for shares include full payment upfront, a loan from the employer, received on shares, dividends, installment (e.g., payment over a set period of six months), and salary sacrifice.

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Eligible employees may receive shares as remuneration or a performance bonus instead of a higher salary.Employees of smaller companies may also get dividends. That means no shareholder rights, such as the ability to vote at an annual general meeting, are given together with the share. However, in larger companies, ordinary shares are typically offered, giving employees an equity investment.Two Basic Types of Employee Share OptionsThere are two basic types of US employee share or stock options. They’re the following:

1. Incentive Stock Option – An incentive stock option or ISO is a special stock option type that meets the Internal Revenue Code’s section 422 requirements, enabling it to receive preferential tax treatment.

2. Non-Statutory Stock Option – A non-statutory stock option or NSO is any stock option that doesn’t fall under an ISO.

Grant of Employee Share Options: Applied RulesThe following rules apply to the granting of ISOs:

• Market Value – On the grant date, the exercise price of ISOs must be no less than 100% the fair market value (FMV) of the underlying stock. When granting to individuals who own more than 10% of the company’s voting power, the exercise price should be no less than 110%. 

• Maximum Share Value – USD$100,000 is the maximum aggregate fair market value of ISO stock that can be exercised in any calendar year. It will be measured on the grant date. The excess shares are treated as NSOs to the extent the limitation is exceeded.

• All-Employee Grant – Provided that their employment commenced on or before the date of granting, ISOs can be granted only to the company’s, parents’, or subsidiaries’ employees on a discretionary basis. Except in cases of disability, employees must exercise the option while employed or not later than three months following termination of employment. If the employee became disabled, they could exercise the ISO for up to one year. In the case of death, an ISO can be exercised anytime so long as it hasn’t expired yet.

• Non-Employee Participation – Prospective employees or anyone who isn’t officially employed with the company yet can’t participate. Even those individuals who already received an offer to take on a position in the company but haven’t yet commenced employment can’t be granted an ISO.

The following rules apply to the granting of NSOs:

• Market Value – On the grant date, the exercise price of NSOs must be at least equal underlying shares’ FMV. The NSO will be treated as a discount option pursuant to the Internal Revenue Code’s section 409A when the underlying shares’ FMV isn’t meet. That means it will suffer related adverse tax consequences.

• Maximum Share Value – No value or any per share limitation is applied to NSOs.

• All-Employee Grant – Non-employee directors, independent contractors, and employees can be granted with an NSO. For employees, they should be employed by the company on or before the date of granting the NSO. Non-statutory stock options can also be granted by employers on a discretionary basis.

• Non-Employee Participation–Non-statutory stock options can’t be granted to prospective employees or those individuals who have been offered a position but haven’t commenced employment yet. However, granting NSOs to non-employees is allowed.

Final ThoughtsEmployee share schemes have undergone changes in terms of tax treatment. Employees will only pay options or shares-related tax upon receiving a financial benefit under the new system. That makes ESS or ESOPs more attractive for employees. To retain their best talent, more and more companies, especially startups, have also opted to enter into these schemes with their key employees. It makes sense; as an employer, you don’t want to be crossing fingers again and again when hiring employees, hoping to get the best people.