If you work for a tech company or startup, you’ve likely been offered employee stock options as an employment incentive. If you are accepting employee stock options as part of your compensation package, it’s critical that you understand what they are and how you might exercise or sell them in the future. A fiduciary financial advisor with experience in employee stock options can be very helpful in understanding your stock options.
Stock options are a form of compensation granted by a company to their investors, contractors, and employees. The exact amount depends on a variety of factors determined by the company, such as your seniority, skills, and stake. Options are like contracts, you are given the option to buy or exercise your negotiated shares of the company’s stock at a pre-set price. Depending on your employer, you will have a set amount of time to exercise your options.
As part of your compensation, you may receive stock options. Here’s an example: upon being hired at startup, you sign a contract with details on the terms of the stock options. The contract says you will receive, say, 20,000 shares over a four-year vesting period, of the company’s stock along with a grant date, meaning when your options begin to vest. You’ll be able to buy those shares once your options vest. The options typically vest gradually, over a period of time stipulated in your contract. In this case, you will be able to exercise all 20,000 options in four years. If your options vest gradually, you can vest some of your options (typically a percentage of the total # of shares).
Before any of your options vest, however, you’ll have to wait for a “cliff.” If your contract includes a one-year cliff, you will need to stay at the company for at least a year to receive your options.
You can exercise your options, meaning buying shares of company stock, once they have vested. Your options have no value until you exercise them. The cost of those options, often referred to as the grant price, strike price, or exercise price, is set in your initial contract and never changes.
If you’re concerned about having to put up the cash to buy all of your options, worry not! There are plenty of ways to exercise your options: you can make an exercise-and-sell transaction, where you purchase your options and sell them immediately. Another option is through an exercise-and-sell-to-cover transaction where you sell just enough to cover your purchase and hold the rest.
Keep in mind your options do expire, so be sure to review your contract to make sure you don’t miss the opportunity to exercise your stock options.
There are a number of factors that determine when you exercise your stock options. If you believe your company will go public, you’ll want to wait until it does. However, if your company never goes public, or you rush to exercise prior to it doing so, your shares could end up being worthless.
If your company does go public, exercise your options only when the market price of the stock is above your exercise price. At this point, it’s about evaluating your stocks to best determine when you would benefit from exercising. Discussing your stock options with a financial advisor, particularly when to exercise, can make all the difference such that you don’t end up paying more in capital gains or on income taxes.
When exercising or selling your stock options, you will typically have to pay taxes. There are two types of stock options, which ultimately determine how you’ll have to pay taxes. The first and most common are non-qualified stock options (NQSOs). These do not receive special tax treatment from the federal government, while incentive stock options (ISOs) are given to executives and receive special tax treatment.
NQSOs are taxed as regular income, which is reported on your W-2. The amount taxed will depend on the difference between the stock’s market value and your exercise price and is known as the compensation element. Additionally, the taxes will be based on the amount of time you held your shares. Federal taxes vary depending on when you exercise your shares, but taxes on long-term capital gains (over a year post-exercising) are typically lower.
While you won’t pay taxes when exercising ISOs, you will need to pay taxes on the sale of the shares. Once more, depending on when you sell, you will or won’t have o pay long term capital gains.
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