Perhaps you’ve been offered a job package with a combination of salary, benefits, and stock options. But you’re trying to decide if you should take those employee stock options and you’re wondering how do options work anyway? Is it worth taking a lower salary offer in exchange for stock options?
The answer depends on a number of things. You certainly want your base salary to cover your expenses, but stock options could give you a sense of ownership (and, to a degree, actual ownership) in the company you work for.
Employee stock options also have the potential to make you some extra money, depending on the market, which might be a nice perk. Before you decide if you want to take the stock options, you might want to understand how options work.
What Are Employee Stock Options?
Employee stock options give an employee the chance to purchase a set number of shares in the company at a set price—often called the exercise price—over a set amount of time. Typically, the exercise price is a way to lock in a lower price for the stock.
This gives you the chance to exercise your options at a point when the exercise price is lower than the market price. You may be able to then make a profit on the shares, but just because you have the stock options doesn’t mean you necessarily want to exercise your options.
When talking about stock options, there are some terms to know in order to understand how options work.
• Grant price/exercise price/strike price: This is the given set price that you can purchase the stock options for
• Market price: This is the current price of the stock on the market (which can be lower or higher than the grant price you would pay, though typically you would only choose to exercise and purchase the options if the market price is higher than the grant price)
• Issue date: The date you’re given the options
• Vesting date: The date after which you can exercise your options per the original terms
• Exercise date: This is the date you actually choose to exercise your options
• Expiration date: You have until this date to exercise your options or they expire
That might seem a little bit complicated, but employee stock options don’t have to be confusing. They’re a way for companies to offer an incentive for employees to help strengthen the company: better company, higher stock prices.
How Do Options Work?
When you’re given stock options, that means you have the option or right to buy stock in the company at the established grant price. You don’t have to exercise options, but you can if it makes sense.
Exercising your options means choosing to actually purchase the stock at the given grant price, after a given waiting period. If you don’t purchase the stock, then the option will eventually expire.
For example, let’s imagine you were issued employee stock options on Jan. 1 of this year with these terms: the option of buying 100 shares of the company at $10/share; you can exercise this option starting on Jan. 1, 2021 (the vesting date) for 10 years, so until Jan. 1, 2031.
If you choose not to exercise these options by Jan. 1, 2031, then they would expire and you would no longer have the chance to buy stock at $10/share.
Now, let’s say the market price of shares in the company goes up to $20 at some point after they’ve vested on Jan. 1, 2021, and you decide at that point to exercise your options.
This means you decide to buy 100 shares at $10/share for $1,000 total, but the market value of those shares is actually $2,000.
There are multiple ways to exercise your options in this scenario. You could just buy the 100 shares with $1,000 cash and you would then own that amount of stock in the company.
Another way is to do a cashless exercise, which means you sell off enough of the shares at the market price to pay for the total purchase. (In this scenario, for example, you would sell off 50 of the shares at $20/share to cover the $1,000 that exercising the options cost you. You would be left with 50 shares.) Most brokerages will do this buying and selling simultaneously.
The third way to exercise options only works if you already own shares. A stock swap allows you to swap in existing shares of the company at the market price of those shares and trade for shares at the grant price.
For example, you might trade in 50 shares that you already own, worth $1,000 at the market price, and then purchase 100 shares at $10/share.
When the market price is higher than the grant price, known as your options being “in the money,” you may be able to gain value for those shares because they’re worth more than you pay for them.
That doesn’t mean you have to exercise your options or that it necessarily makes sense for you. That depends on your financial situation, the forecasted value of the company, and what you plan to do with the shares after you purchase them.
Typically, employee stock options come with a vesting period, which is basically a waiting period after which you can exercise them. This means you must stay at the company a certain amount of time before you can cash out.
The stock options you’re offered may be fully vested at a certain date or just partially vested over multiple years, meaning some of the options can be exercised at one date and more at a later date.
Why Do Companies Offer Stock Options?
Employee Stock Ownership Plans were established by Congress in 1974, though the idea of profit-sharing has certainly gone back further than that. In many ways, the notion is simple: If employees are financially invested in the success of the company, then they’re more likely to be emotionally invested in its success as well and it can increase employee productivity.
From an employee’s point-of-view, stock options offer a way to share in the financial benefit of their own hard work. In theory, if the company is successful, then the market stock price will rise and your stock options will be worth more.
A stock is simply a fractional share of ownership in a company, which can be bought or sold or traded on a market. The financial prospects of the company influence whether people want to buy or sell shares in that company, but there are a number of factors that can affect the price of a stock.
That means there’s no guarantee the stock price will rise if your company is successful. However, one survey from Deloitte found that 69% of people believed employee stock options both increased the ability to attract, recruit, and retain talent, and also more closely aligned the interests of the employees with those of the shareholders.
While stock options were traditionally offered to higher level executives as an incentive, broad-based employee stock options took off during the 1980s and ’90s. According to the Employee Ownership Foundation , at its peak, about 30% of private sector employees have some form of stock options.
The Different Types of Stock Options
There are two main kinds of employee stock options: qualified and non-qualified. These are also known as incentive stock options (ISOs) and non-qualified stock options (NSOs or NQSOs).
The main differences center around taxes. When you buy shares in a company below the market price, you could be taxed on the difference between what you pay and what the market price is. ISOs are “qualified” for preferential tax treatment, meaning no taxes are due at the time you exercise your options—unless you’re subject to an alternative minimum tax.
Taxes are then due at the time you sell the stock and make a profit. If you sell the stock more than one year after you exercise the option and two years after they were granted, then you should only be subject to capital gains tax.
If you sell the shares prior to meeting that holding period, you will pay additional taxes on the difference between the price you paid and the market price as if your company had just given you that amount outright, so it would likely behoove you to hold on to the shares for at least one year after exercise and two years after your grant date.
NSOs, on the other hand, do not qualify for preferential tax treatment, so exercising stock options subjects them to ordinary income tax on the difference between the exercise price and the market price at the time you purchase the stock. Unlike ISOs, NSOs will always be taxed as ordinary income.
Taxes may be specific to your individual circumstances and vary based on how the company has set up its employee stock option program, so you might want to consult a tax advisor.
Should You Exercise Options?
A good first step might be to determine if and when you can exercise options. Vested options are stock options that have hit their vesting date after a waiting period and you can now choose to exercise them, i.e., purchase the shares at the exercise price.
It can be difficult to know if you should exercise options, because it’s hard to know if the market price of the shares is going to go up or down in the future.
Some people wait until right before the expiration date of the options, but you can choose to exercise your stock options at any point after the vesting date and before the expiration date.
There are a number of things you might want to weigh when deciding if you should exercise options: the tax implications and type of option, the financial prospects of the company, and your own portfolio. You also might want to consider how many shares are being sold in the company.
For example, if you’re offered shares worth 1% of the company, but then the next year more shares are made available, you could find your ownership diluted and the stock would then be worth less.
How many shares are being made available, to whom, and on what timeline are factors you could consider when weighing what stock options are worth as part of a job offer.
To Keep or to Sell?
The other thing you may want to consider once you exercise your stock options is whether to keep or sell the shares you’ve purchased. Some companies also have specifications about when the shares can be sold, because they don’t want you to just exercise your options and then sell off all your stock in the company immediately.
But you also probably want to consider how the stock fits into your overall financial portfolio. If you have a lot of stock in one company, if that stock goes up or down, it could have an impact on your financial well-being.
That might be magnified if the company you work for takes a big hit and has layoffs at the same time—you could find yourself both without a job and with company stock options that aren’t worth as much as they once were.
Diversifying Your Portfolio
Instead of holding onto the stock, another thing you could consider is selling the options at a higher market price than you paid for them and then using the cash to diversify your portfolio.
Diversifying your portfolio across a number of companies and industries could help spread out the profit potential and risk. There could be tax implications, though, if you sell too much stock at once, and you may want to consult a tax accountant.
If you do choose to sell your stock options and are considering investing the money in a diversified portfolio, then SoFi Invest® can help you develop a portfolio strategy that works for your financial goals.
SoFi Invest offers both active and automated investing, letting you build a diversified portfolio based on your risk tolerance and financial goals—with zero transaction or management fees. Get started today!
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