Many companies issue stock options for their employees. When used appropriately, these options can be worth a lot of money to you.
- With an employee stock option plan, you are offered the right to buy a specific number of shares of company stock.
- There are two types of stock options that companies issue to their employees: non-qualified stock options (NQs), and incentive stock options (ISOs).
- Your options will have a vesting date and an expiration date. You cannot exercise your options before the vesting date or after the expiration date.
- Keeping too much company stock is risky.
Employee Stock Option Basics
With an employee stock option plan, you are offered the right to buy a specific number of shares of company stock at a specified price called the "grant price" (also called the "exercise price" or "strike price"), within a specified number of years.
Your options will have a vesting date and an expiration date. You cannot exercise your options before the vesting date or after the expiration date.
Your options are said to be “in the money” when the current market price of the stock is greater than the grant price.
Here’s a summary of the terminology you will see in your employee stock option plan:
- Grant price/exercise price/strike price: The specified price at which your employee stock option plan says you can purchase the stock
- Issue date: The date the option is given to you
- Market price: The current price of the stock
- Vesting date: The date you can exercise your options according to the terms of your employee stock option plan
- Exercise date: The date you exercise your options
- Expiration date: The date by which you must exercise your options before they expire
How They Work
To understand how a typical employee stock option plan works, let’s look at an example.
Suppose that on January 1, 2019, you are issued employee stock options that provide you the right to buy 1,000 shares of Widget at a price of $10.00 per share. You must do that by January 1, 2029. On Valentine's Day in 2024, Widget stock reaches $20.00 per share, and you decide to exercise your employee stock options:
- Your grant price is $10.00 per share.
- The current market price is $20.00 per share.
- Your issue date is January 1, 2019.
- Your exercise date is February 14, 2024.
- Your expiration date is January 1, 2029.
To exercise your stock options, you must buy the shares for $10,000 (1,000 shares x $10.00 per share). There are a few ways you could do this:
- Pay cash – You could send $10,000 to the brokerage firm handling the options transaction, and you would receive 1,000 shares of Widget. You could keep the 1,000 shares or sell them.
- Cashless exercise – You could exercise your options and sell enough of the stock to cover the purchase price. The brokerage firm would make this happen simultaneously. You would be left with 500 shares of Widget, which you could either keep or sell.
- Stock swap – You could send in a certificate for 500 shares of Widget, which would be equivalent to $10,000 at the current market price, and this would be used to buy the 1,000 shares at $10.00 per share. You would be left owning a total of 1,000 shares of Widget, which you could either keep or sell.
Types of Options
There are two types of stock options that companies issue to their employees:
- NQs – Non-Qualified Stock Options
- ISOs – Incentive Stock Options
Different tax rules apply to each type of option. With non-qualified employee stock options, taxes are most often withheld from your proceeds at the time you exercise your options. That is not necessarily the case for incentive stock options. With proper tax planning, you can minimize the tax impact of exercising your options.
Your employee stock option plan will have a plan document that spells out the rules that apply to your options. Get a copy of this plan document and read it, or hire a financial planner who is familiar with these types of plans to assist you.
There are many factors to consider in deciding when to exercise your options. Investment risk, tax planning, and market volatility are a few of them, but the most important factor is your personal financial circumstances, which may be different than those of your co-worker. Keep this in mind before following anyone’s advice.
Should You Keep the Stock?
Keeping too much company stock is risky. When your income and a large portion of your net worth are dependent on one company, if something bad happens to the company your future financial security could be in jeopardy. Corporate executives need to consider that in their planning and work to diversify out of company stock.
Frequently Asked Questions (FAQs)
How are employee stock options taxed?
Incentive stock options (ISOs) are taxed differently than nonqualified stock options (NSOs). With an NSO, the difference between the exercise price and the fair market value is subject to ordinary income the year you exercise the option. When you sell the shares, any increase in the sales price is subject to capital gains tax. With ISOs, exercising your options isn't taxable unless you're subject to the alternative minimum tax (AMT). Those with ISOs will pay capital gains when they sell the stocks later on the difference between the exercise price and the sales price.
What happens to stock options when a company is acquired?
What happens to stock options when a company is acquired depends on the details of each acquisition. If your options are vested, you might be able to exercise any "in-the-money" options. Or the acquiring company could substitute its own stock options. If your options aren't vested, they could be canceled, or vesting could be accelerated. It all depends on the terms of the acquisition.