Understanding Your Employee Stock Options
Important things to know before you decide to buy
Many companies issue stock options for their employees. When used appropriately, these options can be worth a lot of money to you.
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 considered 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 do exercise your options
- Expiration date – the date by which you must exercise your options or they will expire
How an Employee Stock Option Plan Works
To understand how a typical employee stock option plan works, let’s look at an example.
Assume on 1/1/2012 you are issued employee stock options that provide you the right to buy 1,000 shares of Widget at a price of $10.00 a share. You must do this by 1/1/2022. On Valentine's Day in 2017 Widget stock reaches $20.00 a share and you decide to exercise your employee stock options.
- Your grant price is $10.00 a share
- The current market price is $20.00 a share
- Your issue date is 1/1/2012.
- Your exercise date is 2/14/2017.
- Your expiration date is 1/1/2022.
To exercise your stock options you must buy the shares for $10,000 (1,000 shares x $10.00 a share). There are a few ways you can do this:
- Pay cash – you send $10,000 to the brokerage firm handling the options transaction and you receive 1,000 shares of Widget. You can keep the 1,000 shares or sell them.
- Cashless exercise – You exercise your options and sell enough of the stock to cover the purchase price. The brokerage firm makes this happen simultaneously. You are left with 500 shares of Widget which you can either keep or sell.
- Stock swap – You send in a certificate for 500 shares of Widget, which is equivalent to $10,000 at the current market price, and this is used to buy the 1,000 shares at $10.00 a share. You are left owning a total of 1,000 shares of Widget which you can either keep or sell.
Types of Employee Stock Options
There are two types of stock options 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. This 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 that 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 considered risky. When your income and a large portion of your net worth is all dependent on one company if something bad happens to the company your future financial security could be in jeopardy. Corporate executives need to consider this in their planning and work to diversify out of company stock.