Stock Options: What Are They and How Do They Work?

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This year the initial public offering (IPO) market has surged to levels not seen since the dot-com boom, and many more companies still plan to IPO in 2021. If your employer is among them, or if you have equity in your company, it’s important to understand how stock options work in order to maximize your potential gains.

Let’s start with the basics.

What Are Stock Options?

Stock options are probably the most well-known form of equity compensation. A stock option is the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise” or “strike price,” for a fixed period of time, usually following a predetermined waiting period, called the “vesting period.” Most vesting periods span follow three to five years, with a certain percentage of options vesting (which means you’ve “earned” your shares, though you still need to purchase them).

You can use Personal Capital’s online dashboard to keep track of your stock options over time. Using the stock options calculator, you can track the current and projected value of your stock options, whether your company has gone public or not. You can see the current value of your options, how many have been vested, and even what they might be worth at a given share price. Time to dream big!

Want to learn more about your stock options? Download our free Guide to Employee Equity Compensation to gain insights from Personal Capital financial advisors. When you download the guide, you also get access to Personal Capital’s suite of award-winning financial tools.

Learn More: Your Guide to Employee Equity Compensation

How Do Stock Options Work?

Stock options are commonly used to attract prospective employees and to retain current employees.

The incentive of stock options to a prospective employee is the possibility of owning stock of the company at a discounted rate compared to buying the stock on the open market.

The retention of employees who have been granted stock options occurs through a technique called vesting. Vesting helps employers encourage employees to stay through the vesting period to get the shares granted to them. Your options don’t belong to you until you have met the requirements of the vesting schedule.

For example, assume you have been granted 10,000 shares with a four-year vesting schedule at 2,500 shares at the end of each year. This means you have to stay for at least one full year in order to exercise the first 2,500 shares and must stay to the end of the fourth year to be able to exercise all 10,000 shares. In order to receive your full grant, you will likely have to stay with your company the full vesting period.

Read More: How to Negotiate Equity Compensation

Exercising and Selling Stock Options

First and foremost, you cannot exercise your options until they are vested.

There may be some agreements that can accelerate the vesting schedule (e.g., in the event of an acquisition), but these are rare. And there are also time limits on when you can exercise or access your options – they typically expire after 10 years from the date of grant. In addition, if you are laid off before you are vested in your options or your company is acquired by another company, you may lose your unvested options.

How to Exercise Stock Options

Once you are ready to exercise your options, you typically have several ways of doing so:

Cash Payment: You can come up with the cash to exercise the options. This would include covering any costs to acquire the stock.

Cashless Exercise: Some employers allow you to exercise your options, and your employer sells just enough of the stock to cover the costs you incurred to acquire the stock.

You can sell all the shares you exercise at the going market price, which means you won’t have any ongoing exposure to any stock price volatility, and you won’t have to come up with the upfront cash for any transaction costs when you exercise. However, the tax implications may not be beneficial, depending on your unique situation.

How to Calculate What Your Stock Options Might Be Worth

There is a relatively simple way to determine what your stock options are worth: If the stock is worth $25/share, and your strike price is $20, then your options will be worth $5 each.

If your company is pre-IPO, it can be difficult to figure out exactly what your stock options might be worth. How much your options could be worth in the future depends on two things: the strike price and future performance of the stock.

Another important point to note when evaluating the value of your options: Options have little value unless the market value is greater than the exercise price, which creates a bit more risk than other forms of equity. If you exercise your options and the price decreases, then you lose both the money you’ve used to exercise the shares as well as any associated taxes.

How Are Stock Options Taxed?

There are two types of stock option: ISOs (Incentive Stock Options) and NSOs (non-qualifies or nonstatutory stock options). The main difference is how they are taxed. With NSOs, you incur a tax bill when you exercise your options. The difference between the fair market value (FMV) and the exercise price is subject to regular income tax for the year. When you sell the shares, any additional gain is taxed at long-term capital gains.

ISOs, on the other hand, aren’t taxed right at exercise. Instead, you’re taxed on ISOs when you eventually sell your shares. However, to qualify for the treatment as capital gains tax on a standard tax return, you must hold the shares two years from grant and one year from exercise (if you don’t meet this requirement, then the sale will be treated as a disqualifying disposition). If these dates are met and the value of the stock increases, you’ll only owe long-term capital gains tax when you sell.

Keep in mind that tax treatment of options can be complex, and how and when you decide to exercise and sell will be highly dependent on your unique situation. Contact your financial advisor or tax professional for specific guidance.

Read More: The Pros and Cons of Hiring a Tax Professional

Our Take

As with any form of employee equity compensation, it’s important to have a holistic understanding of what your stock options are worth and how they fit into your diversified portfolio. You’re putting yourself into a bit of a speculative position when it comes to stock options, so we usually recommend that clients work closely with their financial advisor when evaluating their strategies with stock options.

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