In this article, we’ll explain the basics of stock options and how they work. We’ll also cover the difference between incentive stock options (ISOs) versus non-qualified stock options. Finally, you’ll learn some factors to consider if you’re trying to decide whether to exercise your options.
What Are Stock Options?
Stock options are contracts that give an investor the right (but not the obligation) to buy or sell a stock at a predetermined price. Employee stock options give employees the right (but no obligation) to buy a certain number of company shares at an agreed-upon price. These contracts are often referred to as equity compensation. This type of employee benefit is common at startups and other young companies. Meanwhile, a company that’s in growth mode may offer stock options to make their offers more competitive when they can’t afford to pay higher salaries. For example, suppose you accept a job at a startup that grants you 1,000 shares of options at an exercise price (the price you’ll pay) of $10 a share. Most plans have what’s known as a vesting period before you can exercise your options. If the market value of your shares triples to $30 by the time you’re fully vested, you’ll still be able to buy the shares for $10, or $10,000 total, even though they’re now worth $30,000. Ideally, it’s a win-win for both employees and employers: Knowing they have a stake in the company’s future may motivate employees to work harder, propelling the company even further.
How Employee Stock Options Work
Employee stock options may sound like a great deal if you believe your company will be successful in the future. But there are a lot of details you need to know about these contracts. Here are some basic details you need to know about how employee stock options work.
Strike Price
The strike price is the amount you’ll pay for shares when you exercise your options, meaning you buy the shares you’re granted. Regardless of market price fluctuations, your strike price doesn’t change.
Vesting Schedule
Many employers have a vesting schedule that determines when you’re allowed to exercise your options. If you leave your employer before you’re fully vested, you may forfeit some or all of your stock options. Some companies offer a time-based vesting schedule and grant stock options incrementally or all at once after a certain amount of time has elapsed. Others grant stock options based on performance.
Grant Date
The grant date is the date when you’re officially awarded your stock options. This is important to know because you’ll typically have a limited amount of time, known as the exercise window, to exercise your stock options.
Expiration Date
The expiration date is the date when the contract expires and you can no longer exercise your stock options. Typically, the expiration date is up to 10 years after the grant date.
Blackout Dates
Some plans have blackout dates, which are periods during which your company may restrict exercising stock options. These often coincide with the end of the company’s fiscal year, the end of the calendar year, or dividend schedules.
Incentive Stock Options vs. Non-Qualified Stock Options
The two types of stock options are incentive stock options (ISOs) and non-qualified stock options (NSOs). The main difference boils down to how they’re taxed, with ISOs receiving more favorable tax treatment. Unlike ISOs, NSOs are taxable at the time of exercise. The compensation element, or the discount you get from buying the stock, is the portion that’s taxed. To calculate the compensation element, subtract the exercise price from the market value of the stock.
Tax Rates
As long as you meet the holding requirements, ISOs are taxed at long-term capital gains rates, which are lower than ordinary income rates. However, if you don’t meet the holding requirements, your gains will be taxed at ordinary income rates in the year that you sell. The compensation element of NSOs is taxable when the options are exercised. Your employer must report the income on your W-2. The income is subject to federal, state, and local income taxes, as well as payroll taxes. When you sell your shares, you’ll also be taxed on your gains. If you held your shares for more than a year, you’ll owe lower long-term capital gains rates.
Who Qualifies
ISOs are limited to employees and must be approved by a company’s board of directors. An ISO comes with additional restrictions. For example, ISOs can’t exceed $100,000 per year for any employee. The rules for NSOs are less stringent. Some non-employees, such as board members, contractors, and advisors, may be eligible for NSOs.
Should I Exercise My Employee Stock Options?
If you’re wondering whether you should exercise your employee stock options, you need to weigh several factors, including your financial situation and how you feel about your company’s future. Here’s what to consider.
Current Stock Price
You only want to exercise stock options if the options are “in the money,” meaning your strike price is lower than the market price. If the options are “out of the money,” you could pay less by buying shares through a stock exchange instead of exercising your options.
Company Trajectory
If you’re a very early employee, you may be granted stock options with a strike price of just a few cents per share. In this case, it may make sense to exercise them even though the likelihood of losing your entire investment is high. You’re putting a relatively small amount at risk, and the potential payoff is enormous if the company succeeds.
Your Tax Situation
If you’re considering exercising stock options, it’s essential to consult with a tax professional. If you have NSOs, you’ll be taxed for the current year on the discount. With both NSOs and ISOs, you’ll pay tax when you sell your shares. Delaying the exercise of ISOs could result in alternative minimum tax (AMT) if your shares have appreciated significantly.
Liquidity Needs
With any investment decision, it’s important to consider your immediate cash needs before you invest. That’s especially true if you’re considering exercising your stock options as your company prepares for an initial public offering (IPO). You’ll typically be prohibited from selling your employee shares in the first six months after your company goes public. Because share prices often drop after this lockup period ends, you’ll also want to give time for your shares to recover.
The Bottom Line
Employee stock options can be a valuable benefit when you join an early-stage company, especially if you’re among the first employees. While the potential payoff is huge, there’s also a risk that you could lose everything if the company fails. If you’re considering an offer that includes stock options, consider your other investments before you exercise your options. One common rule of thumb is that a single investment shouldn’t account for more than 5% to 10% of your portfolio. Before you exercise your options, consider both your own financial needs, as well as the company’s chances of success.
