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What are Stock Options & How Do They Work? Complete Guide

If your employer offers you stock options or if you’re thinking about exercising and selling your stock you should read our guide
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“I remember reading an article a while back that said Microsoft employs more millionaire secretaries than any other company in the world. They took stock options over Christmas bonuses – It was a good move.”

– Giovanni Ribisi (Seth Davis), Boiler Room, 2000.

Employers, particularly in the tech sector, use stock options as a means of retaining and attracting talent. Depending on the success of the company, taking stock options could pay off big time for the employee.

If your employer offers you stock options as part of your compensation, or if you’re thinking about exercising and selling your stock, you might want to take a few minutes to brush up on your knowledge of how they work.

Stock Options Explained

Most companies grant stock options as a perk to employees, consultants, contractors, and investors that believe in the future of the company.

Companies will grant these stock options through issuing a contract giving the employee the right to purchase a fixed number of shares at a predetermined price point, known as the “grant price.” When the employee decides to act on this right, it’s called “exercising their options.”

It’s important to note that this initial offer won’t last forever, and the employee has to exercise their right to buy the stock before the contract expires. If you decide to leave the company and you have stock options, your contract might require you to sell your stock before you part ways with the company.

Companies vary in the number of options that they grant their employees. Some companies also only offer stock options to senior management or executives, and the companies investors must first sign-off on any grant contracts before the employee receives their stock options.

How Do Stock Options Work? – Vesting and Granting

Let’s use a simple example to show you how stock options work.

Granting

  • If you start at a new tech firm with plenty of prospects for advancing your career with the company in key management positions, the company might offer you stock options to secure your commitment to the firm.
  • As a result, you receive 20,000-shares of stock as part of your compensation package. You’ll sign a contract with your company outlining the terms and conditions of the sale of the stock to you. Your employer might also attach this agreement as an annexure to your employment contract as well.
  • The stock options contract specifies the grant date, and the grant date specifies the day in which your options begin to “vest.” When the vesting window opens, the stock is officially there for you to buy when you exercise your right.
  • In most cases, companies won’t let you access the total amount of the shares in your contract right away. Instead, they release them slowly over the vesting period, allowing you to show your commitment to the company, and receive a reward for your dedication to the vision and mission of the business.

Vesting

In the case of our example, let’s say that the stock options have a four year vesting period, and the contract also includes a one-year cliff. The four year vesting period means that the company will take four years to release all of the 20,000 shares, usually at 5,000-shares a year, or it might be 2,500-shares every 6-months.

In some cases, a 4-year vesting period might mean that you have to wait for the entire four-year period to expire, and then you get one-year to exercise your stock options and receive shares in the company.

The cliff refers to the period you have to wait before exercising your stock options. It means that you’ll need to remain at the company for at least a year to be eligible to receive any of your stock options. If you decide to leave the company before the one-year cliff expires, then you don’t receive your stock options.

However, if you do decide to stay, then you’ll receive one-quarter of your options (5,000-shares). The balance of your outstanding options will convert into shares over a specified period, usually monthly, until the vesting period expires.

So, with our example, the outstanding 15,000-options vest at rates of 1/36 over the following 36-months, working out to around 416-options vested every month.

How Do Brokers Pick Stocks

How Do You Exercise Your Stock Options?

After your stock options start the vesting period, you have the chance to exercise you’re right to buy the stock. Until you decide to take your stock options, they have no intrinsic value. When you start with the company and formulate your employment contract with your employer, you’ll discuss the details of your stock options as well.

Your employer outlines the price you’ll pay for the stock, nominating the “grant price” you pay when you decide to exercise your options.

In some cases, the contract might also refer to the grant price as the “exercise price” or the “strike price.” Regardless of the company’s performance, the grant price is the price you pay to exercise your stock options.

Let’s say that your employment contract gives you the right to exercise your $20,000 in stock options for $1 per share.

Four years later, you would need to pay $20,000 to exercise your options. If the price of the stock doubles in value over this period, you’re going to make a killing when you exercise your stock options. However, it the price halves, then it’s not as good a deal as you were hoping for all those years ago.

After receiving your shares, your employer might have a lock-up clause that restricts you from selling your shares for a set period. However, most employers will let you sell the shares right away. There might also be a clause that says the company has the first option to buy your shares as well.

If you don’t have any limitations on what you can do with your shares, then you can either sell them for cash or hold them to see how the company does on the market. It’s also important to note that if you decide to sell your shares, there are tax implications and fees to consider when cashing out.

There are a few ways you can exercise your stock options without having to front the cash in the deal. An excellent example of this strategy is making an exercise-and-sell transaction. With this strategy, you exercise all of your options and sell them immediately.

When you initiate the transaction, the broker managing the deal will loan you the capital you need to exercise your options. In this case, you use the money you make for the sale to cover the costs of buying the shares.

Another method to exercise your stock options is to use the exercise-and-sell-to-cover strategy. With this transaction, you sell enough of your shares to cover the amount you need to purchase all of the shares, leaving you with the balance.

As a final thought, it’s also important to note that your stock options come with an expiry date, and you’ll find this date on your employment contract. In most cases, the options will expire 10-years from the nominated grant date.

When Should You Exercise Your Stock Options?

Two defining factors determine your decision on when to exercise your stock options. The first is your financial situation, and the second factor is the price of the company’s stock.

Typically, it’s a good idea to exercise your stock options if the exercise price is lower than the market share price. So, for example, let’s say you have stock options with an exercise price of $1, and share of the stock costs $2 of the open market.

In this example, you would make money if you decided to exercise your stock options and sell them immediately. However, you’ll have to deal with the taxes involved in the transaction, and you might end up giving a chunk of your profits away to the taxman, and fees.

However, if you feel that the company still has plenty of room to grow, you might want to think about holding your shares. It’s important to remember that after exercising your options, they are yours, and you can keep them for as long as you want.

On the converse, if the stock price of your company is lower than the exercise price of your options, you’ll end up losing money if you decide to exercise your options. In this case, you need to use your best judgment. Rely on advice from professionals as to the future of the share price of your company.

If the company is sliding, you might mitigate your losses if your exercise immediately. However, if your financial advisor expects the company to recover, it might be worth it to hold onto your stock.

Dividend Paying Stocks

Taxes and Stock Options

After exercising your stock options, you’ll need to settle your bill with the taxman. The IRS runs a computer system called the DIF, which has all the information on the sale of your stock options. If you don’t file the right forms with the IRS, expect a call from Washington asking you to explain the situation.

The taxes you pay depends on the types of options you have, and the time you wait between exercising and selling your options.

Now’s a good time for us to mention that there are two different kinds of stock options.

Non-qualified stock options (NQSOs), are the most common type of stock options issued by companies. These options don’t receive any kind of special treatment from the federal government when tax season rolls around.

However, incentive stock options (ISOs), which typically end up in the hands of executives at the company, do receive special treatment concerning taxes.

The federal government taxers all NQSOs at the regular income tax rate. your company reports your income on your W-2 form, and the amount of income it reports depends on the “compensation element” or “bargain element.” This element describes the difference between the market value of the stock and the exercise price.

Business Expenses & Tax

Therefore, if you decide to exercise 10,000-options for $1 per share, but the same shares cost $2 on the market, you have a bargain element of $10,000. That $10,000 profit you earn goes into your W-2 form as ordinary income.

When selling your shares, you’ll also have to pay tax based on how long you hold the shares after you decide to exercise them. If you choose to sell within the first year after exercising, the IRS taxes you on a short-term capital gain. As a result, you have to pay the regular federal income tax rate on the transaction.

If you decide to sell your shares after holding them for a year, then the IRS taxes you at a long-term capital gain rate. The taxes you pay on long-term capital gains are lower than short-term capital gains, incentivizing you from selling before the first year is up.

ISOs are a bit different to NQSOs. You don’t have to pay any taxes to the federal or state government when exercising your stock options. However, the bargain element might trigger the alternative minimum tax (AMT). Also, when you sell shares from ISO options, you’ll have to pay your taxes on that sale.

Should you decide to sell your shares immediately after exercising them, then the bargain element registers as regular income.

If you decide to hold the stock for one year after exercising, and you don’t sell for at least two years after your grant date, then you only pay long-term capital gain taxes on the income.

Key Takeaways

  • Stock options are a great strategy for companies to retain and hire talented employees.
  • The terms of the company’s stock options offering come in the form of a contract you need to sign.
  • The contract states the number of options you have, the grant price, and the vesting period.
  • The grant price is the price you pay when exercising your stock options.
  • Deciding on when to exercise your stock options depends on the share price and your situation.
  • You need to take into consideration the tax implications before exercising your stock options.

References

  • https://www.investopedia.com/terms/s/stockoption.asp
  • https://carta.com/blog/equity-101-stock-option-basics/
  • https://www.investopedia.com/articles/active-trading/061615/how-stock-options-are-taxed-reported.asp
  • https://smartasset.com/taxes/stock-options-tax
  • https://www.irs.gov/taxtopics/tc427
  • https://corpgov.law.harvard.edu/2014/10/02/what-has-happened-to-stock-options/
  • https://hbr.org/2000/03/what-you-need-to-know-about-stock-options

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Oliver Dale is Editor-in-Chief of MoneyCheck and founder of Kooc Media Ltd, A UK-Based Online Publishing company. A Technology Entrepreneur with over 15 years of professional experience in Investing and UK Business.His writing has been quoted by Nasdaq, Dow Jones, Investopedia, The New Yorker, Forbes, Techcrunch & More.He built Money Check to bring the highest level of education about personal finance to the general public with clear and unbiased reporting.oliver@moneycheck.com


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