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What are Stock Options, and How Do They Work?

The first time you’re offered stock options, you may have no idea what to do with them—or even how stock options work. Companies often offer stock options as part of an employee’s compensation package. They can be highly rewarding, but only if the company’s stock is doing well when it’s time to exercise your options. Additionally, the  the tax implications can be complicated. If you’re just starting out with stock options, here’s what you need to know. 

What Stock Options Are

When an employer offers an employee stock options, they’re essentially giving the employee the chance to buy a number of shares in the company’s stock for a predetermined price, theoretically below market value. Generally, the employee has to wait a number of years before being able to purchase the shares, known as ‘exercising’ that power. When that waiting period ends, the employee may be able to make a significant profit…if the company’s stock is now worth more than the predetermined price the employee pays. The value of stock options is tied to the performance of the stock. So, if you have options for company stock and the company does well, you’ll share in its success. If the stock doesn’t do well, you won’t make money. 

Companies offer stock options to their employees for several reasons. The first is to encourage employees to stay with the company. You can’t do anything with your stock options until a certain amount of time has passed, and you may lose your options if you leave the company early. Offering stock options also incentivizes employees to work with the company’s long-term growth in mind; this is especially useful at the executive level. 

Cash-strapped companies may also offer stock options to compensate for paying moderate salaries. This is a reason why startups often offer stock options. A company that can’t afford to pay a competitive salary can still attract top candidates by offering them equity in the form of stock options.

How Stock Options Work

When you receive stock options from your employer, all the terms will be laid out in a contract stating the number of shares you’ll be able to buy, and the exercise or strike price of the shares (what you’ll pay when they vest). The contract will include a vesting schedule, dictating how and when you can exercise control of your options. This varies from company to company. Often your stock options vest gradually, so you can exercise a percentage of the options each year. 

You don’t have to exercise your right to buy shares when your options vest, but you do have a limited window to do this. Stock options have expiration dates. Typically, you’ll have no more than 10 years from the grant date to “use or lose” your stock options. If you decide to leave the company after your options vest, you may have a short window to exercise your options before losing them.

As an example of how stock options work, let’s say that your employer offers you the option to buy 5,000 shares at an exercise price of $10 per share with a five-year vesting period. When your stock options fully vest after five years, the market price of the shares is now $25. Your stock options locked you into that $10 price, so you can buy 5,000 shares for $50,000. Now you can turn around and sell your shares for $125,000 (5,000 x $25). Or, if you think the stock price will continue to rise, you can hold onto your shares.

Sometimes, the market value of the company’s stock is lower than the exercise price. Using the above example, let’s say your options fully vest after five years and the market value is $5 a share. Unfortunately, your stock options are worthless. You only make money when the company does well. 

How Stock Options are Taxed

Be prepared for the tax implications of stock options before making any decisions about exercising them. How you’ll be taxed depends on a variety of factors. There are two types of stock options: non-qualified stock options (NSOs) and incentive stock options (ISOs). They’re taxed differently, so it matters which kind you’ve been granted. If you exercise non-qualified stock options, and pay less for the shares than they’re currently worth, the difference between those prices will be taxed like normal income. In the above example, when you pay $50,000 for shares that have a market value of $125,000, the difference of $75,000 is taxed as ordinary income—but only with non-qualified stock options. ISOs don’t have this tax obligation. 

With either kind of stock options, you may owe capital gains taxes if you sell your shares. How long you hold the shares will come into play when determining your capital gain tax obligations, so it’s critical to talk strategy with your financial advisor before exercising any stock options. 

Understanding how stock options work is just the first step in taking advantage of the opportunity you’ve been given. Then you will want to work with your financial advisor to see how your stock options fit in with your financial planning, including tax planning. Be sure to consider diversification, cash flow and tax implications. With an appropriate strategy in place, stock options can be a lucrative element of your portfolio. Contact me with any questions about stock options!