Perhaps you’ve been offered a job package with a combination of salary, benefits, and employee stock options. In order to make an informed decision, it helps to know how employee stock options (ESOs) work. Knowing the basics can be especially important if you’re considering taking a lower salary offer in exchange for ESOs.
Or maybe your current employer has already given you employee stock options, but you’re still not clear on how to exercise them. This is an incentive that could be valuable—so you probably don’t want to ignore it.
Employee stock options have the potential to make an employee some extra money, depending on the market, which may be a nice perk. Stock options can also give employees a sense of ownership (and, to a degree, actual ownership) in the company they work for.
Here is everything you need to know about ESOs—from how they work to the different types, and all the details in between.
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 an employee the chance to exercise their ESOs at a point when the exercise price is lower than the market price—with the potential to make a profit on the shares.
Sometimes, an employer may offer both ESOs and restricted stock units (RSUs)—RSUs are different in that they are basically a promise of stock at a later date.
Employee Stock Option Basics
When talking about stock options, there are some essential terms to know in order to understand how options work. For investors who know their way around options trading, some of these terms may be familiar.
• Exercise price/grant price/strike price: This is the given set price at which employees can purchase the stock options.
• Market price: This is the current price of the stock on the market (which may be lower or higher than the exercise price). Typically an employee would only choose to exercise and purchase the options if the market price is higher than the grant price.
• Issue date: This is the date on which you’re given the options.
• Vesting date: This is 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: This is the date on which your ability to exercise your options expires.
How Do Employee Stock Options Work?
When you’re given employee 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 to you.
Exercising your ESOs means choosing to actually purchase the stock at the given grant price, after a predetermined waiting period. If you don’t purchase the stock, then the option will eventually expire.
ESO Vesting Periods
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 on a certain date or just partially vested over multiple years, meaning some of the options can be exercised at one date and some more at a later date.
For example, imagine you were issued employee stock options on Jan. 1 of this year with 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, until Jan. 1, 2031 (the expiration date).
If you choose not to exercise these options by Jan. 1, 2031, they would expire and you would no longer have the option 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 to exercise your options.
This means you decide to buy 100 shares at $10/share for $1,000 total—while the market value of those shares is actually $2,000.
Exercising Employee Stock Options
You don’t have to exercise your options unless it makes sense for you. That may depend on your financial situation, the forecasted value of the company, and what you expect to do with the shares after you purchase them.
If you do plan to exercise your ESOs, there are a few different ways to do so. It’s worth noting that some companies 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.
Buy and Hold
Once you own shares in the company, you can choose to hold onto them. To continue the example above, you could just buy the 100 shares with $1,000 cash and you would then own that amount of stock in the company—until you decide to sell your shares (if you do).
Another way to exercise your ESOs is with a cashless exercise, which means you sell off enough of the shares at the market price to pay for the total purchase.
For example, you would sell off 50 of your purchased 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.
A third way to exercise options 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 exercise 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 exercise price—often referred to as 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.
Why Do Companies Offer Stock Options?
The idea 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 determine stock price, including investor behavior, company news, world events, and primary and secondary markets.
Tax Implications of Employee Stock Options
There are two main kinds of employee stock options: qualified and non-qualified, each of which has different tax implications. These are also known as incentive stock options (ISOs) and non-qualified stock options (NSOs or NQSOs).
Incentive Stock Options (ISO)
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.
Instead, taxes are 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 will likely only be subject to capital gains tax.
If you sell the shares prior to meeting that holding period, you will likely 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. For this reason, it is often financially beneficial to hold onto ESO shares for at least one year after exercising and two years after your exercise date.
Non-qualified Stock Options (NSOs or NQSOs)
NSOs do not qualify for preferential tax treatment. That means that 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 it’s always a good idea to consult a tax advisor for specifics.
Should You Exercise Employee Stock Options?
While it’s impossible to know if the market price of the shares will go up or down in the future, there are a number of things to consider when deciding if you should exercise options:
• the type of option—ISO or NSO—and related tax implications
• the financial prospects of the company
• your own portfolio and how these company shares would fit into your goals
You also might want to consider how many shares are being made available, to whom, and on what timeline—especially when weighing what stock options are worth to you as part of a job offer. 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.
Employee stock options may be an enticing incentive that companies can offer their employees: the chance to invest in the company directly, and possibly profit from doing so. There are certain rules around ESOs, including timing of exercising the options, as well as different tax implications depending on the type of ESO a company offers its employees.
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