Companies want their employees to be as motivated and engaged as possible to help drive their business forward. As an incentive, companies may offer stock options—which allow employees to buy company shares at a specific price, known as the grant price, for a defined period of time.
Stock options can be offered as part of a comprehensive compensation package that also includes salary and other benefits. If you receive stock options, it’s important to understand exactly what they are and the rules and restrictions for exercising them. Managing employer-granted stock options can require planning to maximize their benefit. Here’s what you need to know.
What are stock options?
Stock options are a type of equity compensation. When granted, the participant is given the right to purchase a specific number of shares of company stock at a set price, known as the grant or strike price. Having stock options doesn’t mean that you automatically own shares of stock in a company. Rather, you have the right to “exercise” or purchase the stock during a specified period of time according to the company’s vesting schedule (more on vesting later). After the options have vested and before they expire, the owner of stock options can exercise the option by purchasing shares at the grant price and choose to hold the shares or receive cash.
How do stock options work?
To offer stock options to someone who works for the company, employers will set aside shares and create a contract for the employee called a stock options grant. The contract (or grant) explains how many shares you can buy and at what price. For example, an employee might be granted the right to buy 1,000 shares at $10 per share during a specified period of time according to the vesting schedule.
Stock options usually have an expiration date. Typically, it’s 10 years (depending on certain factors and the specific circumstances of the company). Up until the expiration date, you can choose to exercise the options. If you don’t, you give up your opportunity to buy shares from the grant.
How does stock options vesting work?
Stock options are not typically accessible when they are granted. Instead, most stock options follow a vesting schedule. Vesting is a process that unlocks your stock options once certain requirements are met. Stock options vesting usually follows a time-based schedule. For example, you might unlock 25% of your options for every year worked until you receive them all after 4 years. If you leave the job before 4 years, you forfeit the unvested options back to the company and can’t use them. It’s important to note that stock options can be granted and may vest on a rolling schedule.What does it mean to exercise stock options?
Exercising stock options means that you buy the shares at the granted strike price. When you exercise, you have to pay your employer the agreed-upon price for the shares according to your contract.
It’s up to you when to exercise the stock options after they have vested and during the life of the contract. You would only exercise if the strike price is lower than the market price, which is known as being “in the money.” The timing decision may hinge on factors that include tax considerations and/or liquidity needs.
Types of stock options
Now that you understand the basics of stock options, let’s look at the 2 types of stock options: Incentive stock options (ISOs) and nonqualified stock options (NSOs).
ISOs can only be granted to employees. NSOs can be granted to nonemployees, like company advisors, contractors, or consultants. Tax rules are another significant difference between ISOs and NSOs.
How are employee stock options taxed?
You do not owe income tax for receiving the initial stock option grant. You may owe income tax when you exercise the stock options depending on the type of stock options you’re granted.
ISOs: If you exercise ISOs, you don’t immediately owe income tax for buying and receiving the shares. It is possible that you could trigger an alternative minimum tax (AMT), which is an extra tax that applies to high-income taxpayers under some circumstances.
When you sell the shares, you owe taxes on the difference between what you paid your employer for the shares and the profit you receive after selling. How much tax you owe depends on when you receive the grant and your timing of exercising the options and selling the shares.
If you wait at least 2 years from receiving the ISO grant and 1 year after exercising the options, your gains are taxed at the lower long-term capital gains rate. If you sell your shares before reaching both milestones, you’ll be taxed the same way as NSOs: You pay ordinary income taxes on the spread between the grant price and fair market value at exercise, and if you hold the shares, then short-term or long-term capital gains are due upon sale of the stock.
NSOs: With NSOs, you owe income tax immediately on the spread between the fair market value and your grant price. For example, if you buy shares at $10 when the market price is $15, you owe income tax on your $5 per share spread. You’re taxed even if you don’t sell the shares immediately after exercising. If you hold the shares, then short-term or long-term capital gains are due upon sale of the stock.
Advantages of stock options
- A chance to share in your company’s success. The better your company performs, the higher its share price could go, making your stock options potentially more valuable over time. And after vesting, you can choose the timing as to when to realize this benefit.
- Leverage. The value of your options will increase at a greater rate than the increase in the company stock. For example, suppose you were granted 100 options at $10. Upon vesting, suppose the shares are worth $11. Suppose again that, at some date thereafter, the shares move to $12. Here, the price of the stock increased by 9%, but the value of your options may have increased from $100 to $200, a 100% gain. (It’s worth noting that this leverage effect also applies if the stock decreases, magnifying the loss of options value).
- Time value: You don’t have to pay taxes until you take action, so gains in the options are tax-deferred and you control when and how much to recognize in taxes.
Challenges of stock options
- Stock options may never become valuable. You might never get anything of value from stock options if they do not become worth exercising or if they do not eventually vest. Remember that stock options are not guaranteed compensation.
- Leaving the company before vesting. As most stock options require vesting, you may not receive this compensation if you leave the company before the stock options vest.
How to exercise your stock options
The exact process for exercising your stock options depends on your company. Here’s a rough step-by-step guide of what to expect:
- Check your options contract for restrictions. Check the fine print of your stock options grant to make sure you’ve met the vesting requirements. You should also see whether your company has any restrictions on what you can do with the shares. For example, blackout periods (such as before earnings reports) can restrict you from exercising your vested stock options. Insiders and corporate officers may face further restrictions.
- Contact your stock options provider. Your company likely uses an online platform to manage employee stock options. To access it, you’ll have an online account where you can pay for and receive the shares using the options. If you aren’t sure how to access this, contact your HR or finance department.
- Decide how you’ll exercise the options. You could pay cash for the shares using your own money or you may be able to exercise and sell shares immediately in a cashless exercise that accounts for any fees and taxes owed.
- Manage the shares. If you decide to keep the shares, they’ll be in your investment account like any other stocks you may own. Note that ISO shares have a holding period to receive more favorable tax treatment.
What happens to your stock options if you leave a company?
It depends on whether the stock options were vested or unvested. If the options are unvested, you will forfeit them back to your company.
If the options are vested, your employer will likely give you a window to exercise. Somewhere between 30 to 90 days is common. You could exercise the option to buy shares or decide not to, depending primarily on if they are in the money. After the window passes, you lose the stock options. If you happen to be leaving a company where you have stock options, check your grant contract to see what post-employment window exists to exercise. If you leave a company but have already bought shares through vested stock options, you keep them after leaving.
Some companies will give retirement-eligible employees longer to exercise their options after the employee leaves. It’s important to know the definition of retirement eligibility and the extent to which (if at all) expiration of the grant is extended.