Employee stock options (ESO) are equity compensation plans offered by companies to their employees as a form of long-term remuneration. When a company sets up an ESO plan, the grantee (the employee receiving the grant) is typically granted the right to buy an agreed quantity of the company’s shares at a fixed price in the future (known as the ‘strike price’).

The employee can also be required to meet certain eligibility requirements (known as a vesting schedule), so that only those who remain in their job long enough are able to make use of the ESO. These arrangements allow employees to become partial owners in the firm, thereby providing an incentive to work hard and create value for the company.

In terms of taxation, ESOs are subject to separate tax regimes. Generally, the employee is liable to pay tax on the difference between the market value of the shares and the strike price when the options are exercised. Further, if the shares are sold on the open market, any profits made will also be taxable at a different rate.

It is important to note that although ESOs are a form of compensation like salary and bonuses, they often have no or very little intrinsic value themselves. Instead, the real value lies in their time value, which decays over time as the strike price moves closer to the current market price. As a result, if the ESO is not exercised before the expiry date, the employee may lose out on some or all of the value they could have gained.

In short, employee stock options represent a source of long-term compensation which, if managed correctly, can have many benefits for the company and its employees. They can provide valuable diversification to an employee’s portfolio, as well as providing additional security against economic downturns and market volatility. Furthermore, ESOs can increase the competitiveness of a company’s total rewards package, thereby attracting the best talent.