One of the reasons that employee stock options can seem intimidating at first is that you may not have the vocabulary to talk about them. It becomes much easier to understand your choices and responsibilities around employee stock options once you speak the language—or at least know what questions you need to ask your financial planner. As you think about stock options as part of your overall financial plan, these are the stock option terms you need to know.
Common Stock Option Terms
• Employee stock options: Employee stock options are essentially contracts through which a company gives an employee the right to buy a set number of shares of company stock, for a predetermined price, at a predetermined point in the future. If the company’s stock price rises, the employee can sell their shares for more than their purchase price and make a profit.
• ISOs (incentive stock options): ISOs are one of the two kinds of employee stock options. The two types work similarly but are taxed differently. ISOs generally have the more favorable tax treatment, and are granted only to employees.
• NSOs (non-qualified stock options): Sometimes abbreviated as NQs or NQSOs, these are the second type of employee stock option. They generally have a less favorable tax treatment than ISOs, and companies can give them to people other than employees. A company may grant NSOs to its employees and/or to consultants, directors, independent contractors and other non-employee service providers.
• Granting: In stock option terms, granting essentially means offering. When your company grants you stock options, you’re being offered the chance to buy shares of stock. It’s your choice whether or not you act on the offer.
• Exercising: When you exercise your options, you’re buying the shares that your employer granted you.
• Grant date/issue date: The grant date or issue date is the date on which you’re officially given your stock options. This is when the clock starts on your vesting schedule.
• Grant price/exercise price/strike price: This is the price you’ll pay per share if you decide to buy the stock when your options vest. If you’re granted 1,000 shares with a grant price of $5, as of your vest date you can buy those shares for $5,000—no matter what their current market value is. (Though it is not required that you buy all available shares.)
• Vesting: When stock options vest, they’re available to you to buy. Stock options don’t have any real, monetary value to you until they vest.
• Vesting schedule: The vesting schedule spells out how long it will take your options to vest. Often, employee stock options vest gradually over the course of several years; for example, your vesting schedule might allow you to exercise 25 percent of your shares starting one year after your grant date, 50 percent after year two and 75 percent after year three. You would be fully vested after year four, at which point you can exercise all of your shares.
• Holding period: If you have ISOs, the holding period determines whether any gains you earn from selling your shares are taxed as regular income or as capital gains. Typically, employee stock options have a holding period of one year from the grant date. If you sell during the holding period, any gains are taxed as income. If you wait one year and one day, until the holding period is over, any gains from the sale will be taxed at the (usually lower) capital gains tax rate.
• Spread: The spread is the difference between the grant price of your shares and the market value of those shares, at the time of exercise. Say that when you buy 1,000 shares for $5,000, the current market value for 1,000 shares is $20,000. The spread is $15,000. With non-qualified stock options, the spread is taxed as ordinary income when you exercise the options.
• Cashless exercise/cash exercise: Let’s say you decide to buy your shares when your options vest. With a cash exercise, you use your own money to pay the grant price; essentially, you’re writing a check to buy the shares outright. If you can’t access enough money to cover the cost, or don’t want to use your own money, you may be able to use a cashless exercise to buy shares. There are a few ways to do this; for example, a brokerage firm may put up the money to buy the shares, then immediately resell them and give you your portion of the proceeds (minus taxes and the firm’s fee).
• Cliff: When options vest gradually, the vesting schedule may include a cliff. This is the point at which your first portion of shares vest. Employee stock options often have a one-year cliff; if you leave the company before reaching this point, you forfeit your shares.
• Expiration date: Employee stock options expire after a certain amount of time. The expiration date is often set as 10 years from the grant date. Once you reach the expiration date, any options that you haven’t yet exercised are worthless.
You may run into these and other unfamiliar stock option terms as you make decisions around your employee stock options. Don’t hesitate to ask your financial planner for help. We’re here to translate and make sure you have all the information you need to make the decisions that align with your financial goals. If you have specific questions deciphering stock option terms, I’m here to help. Contact me today!
Michael J Callahan, CPA, CFP®, MST, Partner, Director- Wealth Management is a Certified Financial Planner™ practitioner, Certified Public Accountant, and holds a Master’s Degree in Taxation from Bentley University. Mike has been involved in personal financial planning, as well as both business and individual taxation for more than 15 years.