Employee stock options

Quick summary

Employee stock options give workers the right to buy company shares at a fixed price. They are a way for companies to pay employees using ownership. Options can be very valuable. They can also be confusing. This guide explains the main ideas, the common types, taxes, and practical choices.

What are employee stock options?

An employee stock option is a contract. It lets an employee buy a set number of company shares at a set price. That set price is called the strike price or exercise price.

You only profit if the market price of the shares goes above the strike price. If it does, you can buy at the low strike price and sell at the market price. If the market price never goes above the strike price, the option may be worthless.

Key terms

• Grant: The company gives you the option.
• Strike price: The price you pay to buy one share.
• Vesting: When you earn the right to exercise some or all of your options.
• Cliff: A first vesting date where a chunk vests at once.
• Exercise: Buying the shares at the strike price.
• Expiration: The last date you can exercise the option.
• Fair Market Value (FMV): The current value of a share.

Two common types

• Non-qualified stock options (NSOs or NQSOs)
  • Simpler. When you exercise, the difference between FMV and strike price is taxed as ordinary income.
• Incentive stock options (ISOs)
  • Have special tax rules. If you meet holding rules, gains may be taxed as long-term capital gains, which is lower. But exercising ISOs may trigger alternative minimum tax (AMT).

Companies vary in which they offer. Startups often give ISOs to key employees.

How the process works

1. Grant: Company gives you options, with a strike price.
2. Vest: Over time you earn the right to exercise. A common schedule is four years with a one year cliff.
3. Exercise: You pay the strike price and get shares. You may need cash to exercise.
4. Hold or sell: You can sell immediately or hold for a price increase and tax benefits.
5. Expiration: After a set time, usually 10 years, your options expire.

Example with numbers

You get 1,000 options with a strike price of $1.00. The company shares later trade at $10.00.

• Value per option at $10: $10.00 - $1.00 = $9.00
• Total value: 1,000 x $9.00 = $9,000

If you exercise and sell immediately, taxes and fees reduce this amount. If you hold, tax treatment may change.

Taxes in plain language (US)

• NSOs: At exercise, the difference between FMV and strike becomes ordinary income. You pay payroll taxes and income tax then. Later gains or losses from selling the shares are capital gains or losses.
• ISOs: If you follow the holding rules you may get long-term capital gains on the full increase at sale. But exercising ISOs can trigger AMT in the tax year you exercise. If you do not meet the holding rules, the favorable ISO treatment is lost and you pay ordinary income tax on the bargain element.

Holding rules for ISOs:

• Sell at least two years after the grant date
• And at least one year after the exercise date

Note: Tax law changes. Always check current rules or ask a tax advisor.

Common strategies

• Early exercise: Some startups let you exercise early when strike price is low. You may file an 83(b) election within 30 days. That can reduce tax later but is risky. If the shares drop to zero you lose money and you cannot get your tax back.
• Cashless exercise: Brokerage sells some shares at exercise to cover the cost and taxes. Useful if you lack cash.
• Hold for longer: If you expect big growth and you can cover taxes, holding might give better tax rates for ISOs.
• Diversify: Do not bet your life savings on company stock. Sell some to spread risk.

Pros and cons

Pros:

• Upside if company grows
• Aligns employee and company interests
• Can be tax efficient with ISOs

Cons:

• Can expire worthless
• Complex taxes
• Requires cash to exercise in many cases
• Risk of holding too much company stock

Checklist before you act

• What type of option do you have? NSO or ISO?
• What is the strike price and current FMV?
• What is your vesting schedule and expiration date?
• Do you have cash to exercise and pay taxes?
• Are there company rules, like blackout periods or trading windows?
• Have you talked to a tax advisor?

FAQ

Q: Are stock options the same as restricted stock units? A: No. RSUs are a promise to give shares later or cash equal to shares. They do not require buying at a strike price.

Q: What happens if I leave the company? A: Usually you have a short window, often 90 days, to exercise vested options. Unvested options are typically forfeited.

Q: Can options be transferred or sold? A: Most employee options are not transferable. Some companies allow limited transfers.

Final thought

Employee stock options can create real wealth. They come with rules and risks. Understand the type, the timeline, the tax effects, and the cash needs. When in doubt, ask a tax pro and do the math.