Employee stock options are a form of equity compensation that companies may offer to their employees. They are often granted as an incentive to motivate and retain employees, align their interests with those of the company, and provide them with a potential financial reward if the company’s stock price increases.
What are Employee Stock Options?
Employee stock options are a type of employee benefit that provides employees the right, but not the obligation, to purchase company shares with a predetermined quantity, price, and timeframe. These options are typically granted as part of an employee’s compensation package and can be a way for employees to share in the potential growth and success of the company.
Exercising Stock Options
Exercising employee stock options refers to the process of converting the granted options into actual shares of the company’s stock. The employee becomes a shareholder of the company and is entitled to the benefits and risks associated with owning the company’s stock.
Eligibility and Vesting: Before an employee can exercise their stock options, they must first meet the eligibility requirements set forth in the stock option plan agreement, such as completing a certain period of employment or achieving performance milestones. Stock options are typically subject to a vesting period; think of vesting as the timeframe in which one has access to the option. Common vesting schedules are gradual (or graded) and cliff, or a combination of both. Let’s say an employee is granted 1,000 shares of a stock option with a four-year vesting period. With a gradual vesting period, they may exercise 25% of the options (250 shares) after the first year, and the remaining options vest equally over the remaining three years. With cliff vesting, 100% of the shares are available for exercise after four years.
Exercise Price: The exercise price, or strike price, is the cost at which the employee can purchase the company’s stock. This price is typically predetermined and set at the fair market value of the stock at the time of grant.
Expiration Date: All stock options plans set a predetermined last date in which the employee can exercise their stock option. A common expiration date is ten years from the grant date.
Valuation: Since a stock option provides the right but not the obligation to purchase company stock, the option is only valuable when the market price of the stock is greater than the strike price, which is referred to as “in-the-money” or the option’s intrinsic value. When the market value is less than the strike price, the option is “out-of-the money.”
The valuation of employee stock options may also depend on whether the options are traded on a public market or are privately held. Publicly traded stock options are typically valued based on the prevailing market prices, while privately held stock options may require a private valuation that takes into consideration factors such as the lack of marketability and lack of liquidity, which can impact their value.
There are three main methods of exercising stock options
1. Cash for Stock: Exercise-and-Hold: The employee pays the exercise price in cash to the company in exchange for the shares of stock, and the employee keeps the shares. This method requires the employee to have sufficient funds to cover the exercise price and any applicable taxes.
2. Cashless: Exercise-and-Sell: The employee purchases the shares and immediately sells them. In some cases, the employee does not have to use their cash for the purchase as the sale proceeds of the stock cover the purchase.
3. Cashless: Exercise-and-Sell-to-Cover: The company withholds a portion of the exercised shares to cover the exercise price and taxes, and the remaining shares are issued to the employee.
Stock Ownership and Rights
Once the stock options are exercised, the employee becomes a shareholder of the company and is entitled to the rights and benefits associated with stock ownership, such as voting rights, dividend rights, and potential stock price appreciation. The employee can hold onto the shares for potential capital gains or sell the shares in the open market, subject to applicable trading restrictions or insider trading rules.
There may be costs associated with exercising stock options, like transaction fees. Depending on state and local tax rules, an employee may also be required to meet tax withholding requirements on exercised options. It’s also essential to be aware of any trading restrictions, blackout periods, or insider trading rules that may apply to the company’s stock, as these can impact the timing of exercising and selling stock options.
Types of Stock Options and Taxation
There are two primary types of employee stock options, and you may hear them referred to by various names, such as qualified or non-qualified. These are IRS terms indicating whether a plan or policy meets certain tax or legal requirements, and generally qualified plans have preferred tax treatment while non-qualified plans do not.
Non-qualified stock options (NQSOs)
Also known as non-statutory stock options (NSOs). This type of stock option is most common, and the bargain element of exercised options is considered ordinary wage income for income tax purposes.
For example, if you have a stock option with a strike price of $100, and you exercise the option at the fair market value price of $150, you will pay ordinary income taxes on the difference of $50 per share – this is referred to as the bargain element.
Typically, your company would withhold taxes on the bargain element on your behalf. The date of the stock option exercise is now the acquisition date of the company stock, and the fair market value of the stock on this date is now the purchase price and cost basis of the shares.
If the shares are held for more than one year from the exercise date, any capital gain or loss will be considered long-term, and any long-term gains are taxed at preferential rates. If the shares are held for one year or less, any capital gain or loss will be considered short-term, and any short-term gains are taxed based on your marginal tax bracket.
Let’s assume the employee is in the 35% tax bracket, and they exercised their stock option grant today when the fair market value of the company stock is $150 per share – this is now the cost basis of the owned shares received. Let’s say the employee sells the stock six months from today at $160 per share; they would pay short-term capital gains tax of 35% on the $10 per share profit. If the shares were sold one year and one week from today at $175 per share, the employee would pay long-term capital gains tax of 20% on the $25 per share profit.
They are sometimes referred to as qualified or statutory stock options, and they have preferential tax treatment and more rigid requirements. Unlike NQSOs, the bargain element of exercised ISOs is not considered ordinary wage income. Rather, the bargain element is treated as an add-back item for Alternative Minimum Tax (AMT) calculations. Depending on the significance of the bargain element realized, exercising ISOs could trigger AMT in the current year. The maximum AMT marginal rate is 28%.
For an ISO to maintain its qualified status, it must be held for more than one year from the date of exercise and two years from the time of the grant. If an employee exercises their ISOs and then sells the stock without meeting the holding period requirement, the ISOs become disqualified and are treated as NQSOs for income tax purposes.
Due to the complicated nature and timing considerations of stock options, we recommend working with a financial advisor or tax professional to develop an exercise plan that considers your personal goals, liquidity, and options available.
Employee Stock Options vs Restricted Stock Units
While both stock options and restricted stock units (RSUs) provide employees with the opportunity to share in the potential growth of the company, options and shares differ in terms of ownership, exercise price, vesting, and liquidity.
Employee stock options do not grant ownership of the stock until exercised, while RSUs typically grant ownership of company shares once vested.
For stock options, the exercise price is predetermined and fixed, allowing employees to potentially realize a profit on the bargain element if the stock price increases. With RSUs, there is no exercise price, as the shares are granted outright to the employees without requiring any additional purchase.
Stock Splits and Employee Stock Options
Publicly traded companies may initiate a stock split for several purposes. One intention may be the stock price has increased to a point where it is too high for investors to buy shares or for employees to exercise their stock options, and the split lowers the price to a more attainable level. Existing shareholders receive additional shares dependent upon the split ratio, but the total value of their shares remains the same, and the original purchase price is also adjusted to ensure unrealized gain is also unchanged. Any future purchases of the shares would now be at the new split price.
As a stock option grantee, this same approach is applied to current grants. Let’s say you have a stock option grant of 1,000 shares with a strike price of $100, and the current market price of the stock is $300 per share. The company announces a 2:1 split. As a result, the market price decreases to $150, and the stock option quantity increases to 2,000 shares with an adjusted strike price of $50.
Advantages and Disadvantages of Employee Stock Options
Employee stock options may serve as a powerful motivational tool to attract, retain, and incentivize employees. Companies can create a sense of ownership and alignment of interests, as employees have a financial stake in the company’s performance. Granting stock options as a piece of employee compensation can be particularly attractive for young companies who may not have the current cash flow for larger salaries and bonuses.
One of the primary advantages of employee stock options is the potential for financial rewards if the stock price increases. This can provide employees with the opportunity to share in the growth of the company and potentially earn a return on their investment. However, tying employee compensation to the performance of a company stock can also be a disadvantage if the price declines or remains stagnant, potentially leaving the employee with worthless stock at expiration. Proper education and understanding of stock options are important to make informed decisions and mitigate risks as an employee and investor.
Employee stock options are typically subject to vesting schedules, which means that employees must remain with the company for a certain period of time before their stock options become exercisable. This can encourage employees to take a long-term view of their employment with the company, as they have an incentive to stay and contribute to its success over the long term. If the employee leaves the company for a different opportunity, they may accelerate the stock option expiration date and could forfeit a portion or all their grants, leaving a piece of their compensation behind.
Employee stock options may require employees to use cash to exercise the options and purchase the stock. This can be a financial barrier for employees, especially if the exercise price is high or if they do not have the necessary funds readily available. Additionally, once the stock options are exercised and the stock is purchased, employees may face challenges in selling the stock or obtaining liquidity, as it may be subject to restrictions or lock-up periods.
If an employee holds a significant amount of stock options relative to the size of their total net worth, whether they have been unable to exercise and sell due to trading restrictions or they are waiting for a particular price, they are subject to concentration risk. An employee receiving any form of equity compensation, especially stock options with an expiration date to consider, should have a diversification strategy where they maximize the value of their compensation while gradually reducing the risk of their company exposure.
What Happens to Stock Options When You Leave an Employer?
The treatment of employee stock options when leaving a company depends on several factors, including the terms and conditions of the stock option plan and the specific circumstances of the employee’s departure.
If leaving a company for a different job opportunity before their stock options have fully vested, the company may accelerate the stock option expiration, and the employee would forfeit the unvested portion of their stock options. Most stock option plans have a defined exercise period during which an employee can exercise their vested stock options after leaving. This exercise period may vary but is typically a few months to one year from the termination date. If the former employee has not exercised their vested stock options within the applicable exercise period, the stock options may be forfeited and no longer available for exercise. If the company departure is caused by termination, all vested and unvested stock option grants could be forfeited.
Some stock option plans may have special provisions for employees who leave the company due to major job or life events such disability, retirement, or death. These provisions may include accelerated vesting or adjusted exercise periods for stock options. Many stock option plans list a beneficiary in the case of death, such as a surviving spouse.
If a company goes through a change in control, like a merger or acquisition, the treatment of employee stock options may be subject to specific provisions, including accelerated vesting or extended exercise periods.
It is important for employees to carefully review the stock option plan, stock option agreements, and any other relevant documents, and seek professional advice to fully understand the treatment of their stock options when leaving a company.
Start-Up Companies and Employee Stock Options
Start-up companies may grant employee stock options as part of their overall compensation package to attract talent, especially in the company’s early years when cash flow may be light.
Start-up companies often have a higher level of risk compared to established companies, and the value of their stock options may be more volatile. However, if the company is successful and its value increases, employees may stand to greatly benefit from the potential upside through the appreciation in the stock price. The value of stock options in start-up companies can be challenging to determine, as the stock may not be publicly traded and there may be limited information available on the company’s financials.
Nonqualified stock options are more common than incentive stock options with start-up companies. Vesting schedules can vary, but they often range from one to four years, with a portion of the options vesting over time, such as monthly or annually. Often employees will need to pay the exercise price to acquire the underlying shares when they choose to exercise their options rather than exercising a cashless exercise option. If the company is acquired or issues an initial public offering, stock option grantees may have more opportunities to exercise without needing to use cash.
Financial Planning Considerations
Stock options can be complex financial instruments, and employees may benefit from seeking professional financial planning and tax advice to understand the financial implications of their stock options, including the timing of exercising options, potential tax liabilities and planning opportunities, and strategies for managing stock options as part of their overall financial plan.
Employee stock options can create a lack of diversification in employees’ investment portfolios. If employees hold a significant portion of their wealth in the form of company stock, they may be exposed to concentration risk. If the company’s stock price declines, employees may not only lose the potential value of their options but also face a decrease in the value of their overall investment portfolio.
How does one decide which stock option grant to exercise first, and then next? And how many shares of each grant? It’s never as simple as exercising when the shares vest as the options may be out-of-the-money within that timeframe; if the options are in-the-money, one could be leaving future growth on the table if exercising too soon. A financial advisor with experience in equity compensation can analyze your company stock exposure related to stock options, RSUs, and owned stock; help you understand the value and risks involved; and develop a proactive approach to diversification.
Other factors financial advisors incorporate into their proposed exercise schedule are a client’s tax situation and their cash flow. One needs to consider and understand whether they have the means to pay for the shares, what tax implications the exercise will create, and if there could be a year that is more optimal to exercise than another from a projected tax rate perspective.
Of course, the only thing constant is change, and all these factors will change over time – the current market price of the stock, one’s goals and priorities, tax law, etc. – so any recommended strategies should be revisited on a regular basis with your advisor.
Equity compensation, including employee stock options, can be complicated. At Schultz Financial Group, we consider your personal circumstances and financial goals in order to make appropriate recommendations. Schedule your introductory meeting today so that we can discuss your goals and how to achieve them with your employee stock options.