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Monday, June 17, 2024

What are stock options & how do they work?

What are stock options & how do they work?

03.10.2022

Employer stock options can be complicated and nuanced. In short, a stock option gives you the right to buy company shares at a pre-set price that’s hopefully lower than the current share price. In this article, we’ll talk about what employer stock options are, how they work, and how to calculate what your stock options might be worth.

In 2020, the initial public offering (IPO) market surged to levels not seen since the dot-com boom, and more than twice as many companies listed in 2021. If your employer is among them, or if you have stock options in your company, it’s important to understand how they work in order to figure out their place in your long-term financial plan.

Let’s start with the basics.

What are stock options?

Stock options are probably the most well-known form of equity compensation. A stock option is the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise” or “strike price.” You take actual ownership of granted options over a fixed period of time called the “vesting period.” When options vest, it means you’ve “earned” them, though you still need to purchase them.

You can use Empower’s online dashboard to keep track of your stock options over time. Using the stock options calculator, you can track the current and projected value of your stock options along with their vesting schedule, whether your company has gone public or not.

How do stock options work?

Stock options are commonly used to attract prospective employees and to retain current employees.

The incentive of stock options to a prospective employee is the possibility of owning stock of the company at a discounted rate compared to buying the stock on the open market.

The retention of employees who have been granted stock options occurs through a technique called vesting. Vesting helps employers encourage employees to stay through the vesting period in order to take ownership of the options granted to them. Your options don’t truly belong to you until you have met the requirements of the vesting schedule.

For example, assume you have been granted 10,000 shares with a four-year vesting schedule of 2,500 shares at the end of each year. This means you have to stay for at least one full year in order to exercise the first 2,500 options and must stay to the end of the fourth year to be able to exercise all 10,000 options. In order to receive your full grant, you typically have to stay with your company the full vesting period.

Exercising and selling stock options

First and foremost, you cannot exercise your options until they are vested.

There may be some agreements that can accelerate the vesting schedule (e.g., in the event of an acquisition), but these are rare. And there are also time limits on when you can exercise or access your options – they typically expire between 5 to 10 years after the date of grant. In addition, if you are laid off before you are vested in your options, you may lose your unvested options.

How to exercise stock options

Once you are ready to exercise your options, you typically have several ways of doing so:

  1. Cash payment: You can come up with the cash to exercise the options at the strike price.
  2. Cashless exercise: Some employers allow you to exercise your options by selling just enough of them to cover the costs of exercising others.
  3. Cashless exercise/sale: Some employers allow you to exercise and immediately sell your options at the current market price, which means you won’t have any ongoing exposure to any stock price volatility, and you won’t have to come up with any cash up front to exercise.

How to calculate what your stock options are worth

There is a relatively simple way to determine what your stock options are worth: If the stock is worth $25/share, and your strike price is $20, then your options will be worth $5 each.

If your company is pre-IPO and you’re unable to sell any shares, it can be difficult to figure out exactly what your stock options might be worth later, because the future price of the shares is unknown.

Another important point to note when evaluating your options is that they have little to no value unless the share price is greater than the exercise price. Finally, if you exercise your options and the price decreases, then you lose both the money you’ve used to exercise the shares as well as any associated taxes. All of these factors mean stock options (and all forms of equity compensation in general) create more risk than just getting paid in cash.

How are stock options taxed?

There are two common types of stock options: ISOs (Incentive Stock Options) and NSOs (non-qualified or non-statutory stock options). The main difference is how they are taxed. With NSOs, you realize ordinary income when you exercise your options, based on the difference between the fair market value (FMV) and the exercise price. When you sell the shares, any additional gain is taxed as capital gains or losses.

ISOs, on the other hand, aren’t taxed as income right at exercise. Instead, the difference between the strike price and exercise price may cause the Alternative Minimum Tax (AMT) to apply if you hold the shares past year-end. When the shares are sold, they’re taxed at long-term or short-term capital gains rates depending on how long you held them after exercise.  For long-term capital gains treatment, you must hold the shares more than two years after grant and more than one year after exercise. If you sell the shares before either of these holding periods is met, they receive short-term capital gains treatment.

Keep in mind that tax treatment of options can be complex, and how and when you decide to exercise, and sell will be highly dependent on your unique situation. Contact your financial advisor or tax professional for specific guidance.

Our take

As with any form of employee equity compensation, it’s important to have a holistic understanding of what your stock options are worth and how they fit into your diversified portfolio. You’re putting yourself into a bit of a speculative position when it comes to stock options, so you should consider working closely with your financial advisor or other financial professional when evaluating your strategies for your stock options.

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The Currency editors

Staff contributors

The CurrencyTM, a publication from Empower, covers the latest financial news and views shaping how we live, work, and play. We keep you current on ways to plan, save, and invest for life.

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