What stock options are and how you should handle them
Published June 10, 2019|7 min read
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A stock option grant is a contract from your employer that gives you the right to purchase shares of company stock
Stock options are only yours to use after they _vest_, which requires you to work at the company for a certain length of time
You don’t own any shares until you _exercise_ your options, meaning you pay for the shares
Exercising options will usually increase your annual tax bill, based on the value of the shares
Stock options are a contract from your employer that allows you to buy shares of company stock in the future. Your contract will explain how long you need to work at the company before you have access to the shares, how much the shares will cost you, and when they will expire if you don’t buy them.
Stock options are a common way for companies, especially startups, to compensate employees beyond simply offering higher salaries. Options are a gamble, though. While they could make the employee a lot of money in the future if the company is successful — like if the company goes public — they could also be worthless if the employee doesn’t work there long enough or if the company isn’t successful.
Employee stock options can also be confusing because they basically come with their own language — granting, vesting, exercising, bargain elements. Below we’ll explain everything you need to know about stock options so that you can feel confident accepting them and (hopefully) making some money off them.
A stock option is a contract an employer offers to some employees and investors, allowing them to buy a specified number of shares of the company’s stock at a predetermined price, called the exercise price. But you normally have to wait a certain amount of time, called the the vesting period, before you’re actually eligible to buy the shares. Once your options have vested, you also have to buy the shares within a certain period of time or they will expire.
Before you can do anything with stock options, you have to wait until they have vested, which means that they are actually yours to buy (at the exercise price) and do whatever you want with.
Employee stock options usually have a vesting period of four or five years, during which all your options will vest at a steady rate according to a vesting schedule. The schedule starts on your grant date — the day you sign the stock option contract — and it ends on the vesting date — the date when all of your options have vested and are available for you to buy. (Vesting stops if you leave the company.)
A common vesting schedule is four years with a one-year cliff, which means that you need to work at the company for at least one year in order to get any of your options. In many cases, one-quarter of your stock options vest on your one-year anniversary and then a portion of the remaining options will vest each month until all of your options have vested.
After vesting you can exercise your options — actually buy the shares of stock. The shares are not yours until you exercise them, so you can’t sell them or earn any money yet.
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Your exercise price, also called the grant price or strike price, is the price at which you can buy the shares of stock that your company granted you. (Remember, you cannot buy them until they vest.) The exercise price is written in your stock option contract and it won’t change, even though the market value of the company’s stock may change.
In the best circumstances, your company’s market value will rise and share prices will be worth significantly more than your exercise price, putting you and your shares “in the money,” with the potential to earn big.
Your stock options will expire if you wait too long to exercise them. If you never leave your company, you usually have 10 years or more after your date before options expire. Once you leave the company, you usually have a set period of time (90 days is common) to exercise your vested options. You can exercise as many or as few as you want and can afford, but any you don’t exercise will expire. You may be able to request an extension.
Once your options have vested, you can exercise them. You aren’t obligated to exercise options, though, and you can also hold them for as long as you want (as long as they don’t expire).
There are a few ways to exercise your stock options:
A simple purchase where you pay the full price of the shares and any other fees
An exercise and sell (also called a cashless sell exercise)
An exercise and sell to cover (also called a cashless hold exercise)
The most straightforward way to exercise your employee stock options is to just pay for them upfront. You will probably have to pay brokerage fees in addition to the cost of buying the shares. This is sometimes called an exercise-and-hold transaction since you’re holding onto the stock instead of selling it after you exercise.
With this transaction, you exercise your options to buy company stock, then immediately sell those shares. The value of the share you sell will help to pay for the purchase price plus any other fees, and then you will get the remaining amount. You won’t have to front any cash, since the transaction is happening all at once. An exercise-and-sell transaction is also called a cashless sell exercise.
A cashless hold exercise happens when you exercise your options and immediately sell enough to cover the purchase price (plus additional fees) and hold the rest.
Employee stock options are still subject to taxes, but there are two types of stock options and taxes apply differently. Most people have non-qualified stock options (abbreviated as NSOs or NQSOs), which count as regular income when you exercise them. (Learn more about the federal income tax rates.)
If you have incentive stock options (ISOs), which are more common for high-level employees, you may have to pay an alternative minimum tax (AMT) when you exercise. (Incentive stock options are also called qualified stock options.)
Non-qualified stock options are the more common type of option and can be offered to company advisors, contractors, or employees. The IRS considers exercising NSOs a taxable event and they do not have special tax incentives, so they are taxed as regular income when you exercise them.
The exact taxes you pay depend on your bargain element, which is the difference between your strike price (the price you pay to buy a share) and the market price on the day you exercised your option. The bargain element may also be called a compensation element.
Bargain element = market value price at exercise date - strike price
As an example, let’s say you buy 1,000 shares at a $1 strike price, at a time when the market value of a share is $3. The bargain element would be $2,000 ($2 difference per share x 1,000 shares) and your taxable income for that year increases by $2,000. (Brokerage fees you pay to buy shares may be added to your purchase price, thus decreasing your compensation element.)
Typically reserved for more high-level employees, buying incentive stock options is not a taxable event, so nothing is added to your regular income in most cases.
The only exception is that some high-income individuals could be subject to the alternative minimum tax, which could then be assessed on your bargain element (as discussed above). The AMT was intended to prevent wealthy people from working within the tax code to avoid paying income tax (such as by taking many tax deductions). The AMT does not affect most taxpayers after the Tax Cuts and Jobs Act of 2017.
With all types of stock, you are subject to capital gains tax when you sell them. A capital gain occurs when you sell a capital asset (like a stock, a house, or other valuable property) for a profit. If you sell something for a loss, you have a capital loss and it will decrease your overall tax bill.
Capital gains tax has two sets of rates: the short-term capital gains rates apply when you sell something after one year or less, and the long-term capital gains rates apply when you sell something after holding it for more than one year. Long-term capital gains rates are lower.
Learn more in our guide to capital gains tax.
How long you hold your options depends on your individual circumstances. Based on the type of stock options you have (NSO vs ISO), make sure to consider what taxes you’ll pay if you exercise your options. In many cases, people try to wait to exercise their options until market prices are as low as possible, meaning their bargain element (and income tax bill) will be lower. Your company’s stock price may also increase greatly if you expect your company to launch an IPO in the near future.
Reading the stock market is difficult and it’s anything but foolproof, so always make sure to honestly consider how much risk you’re willing to take on and to set realistic expectations before buying any stock.
If you need help deciding whether or not you should exercise (or sell) your employee stock options, you may want to talk to a financial advisor.
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