How Employee Stock Options Work: Explanation and Examples (2024)

Stock options are something most people have heard of, but you might not know exactly how they work. In brief, stock options are a type of alternative compensation that some companies, including many startups, offer as part of their package for employees. Employees come on board at perhaps a lower-than-normal salary in exchange for the possibility of a big payday later on. If you’ve been offered options as part of a compensation package, or if you’re considering exercising and selling those options, be sure you know how they work.

A financial advisorcan help you create a financial plan for your stock options or any other investments.

What Are Stock Options?

Stock options are a form of compensation. Companies can grant them to employees, contractors, consultants and investors. These options, which are contracts, give an employee the right to buy, or exercise, a set number of shares of the company stock at a preset price, also known as the grant price.

This offer doesn’t last forever, though. You have a set amount of time to exercise your options before they expire. Your employer might also require that you exercise your options within a period of time after leaving the company.

The number of options that a company will grant its employees varies, depending on the company. It will also depend on the seniority and special skills of the employee. Investors and other stakeholders have to sign off before any employee can receive stock options.

Stock Option Granting and Vesting Basics

To help you understand how stock options work, let’s walk through a simple example.

Suppose you get a job at a startup, and as part of your compensation, you receive stock options for 20,000 shares of the company’s stock.You and the company will need to sign a contract that outlines the terms of the stock options; this might be included in the employment contract.

The contract will specify thegrant date, which is the day your options begin to vest. When a stock option vests, it means that it is actually available for you to exercise or buy.Unfortunately, you will not receive all of your options right when you join a company; rather, the options vest gradually, over a period of time known as the vesting period.

In this case, let’s say the options have a four-year vesting period, with a one-year “cliff.” A four-year vesting period means that it will take four years before you have the right to exercise all 20,000 options.

The good news is that, because your options vest gradually over the course of this vesting period, you’ll be able to access some of your stock options before those four years are up. In our example, it’s likely that one quarter (5,000) of your options will vest each year over the course the four-year vesting period. So by Year 2 of your employment, for instance, you’ll have the right to exercise 10,000 options.

The bad news is that there’s a waiting period before any of the options vest. This is where that one-yearcliff comes in: This means that you will need to stay with the company for at least one year to receive any of your options. If you leave the company before reaching the one-year milestone, you won’t get any options.

After you reach that one-year cliff, you’ll get your first 5,000 options (one-quarter of the 20,000); then, your remaining options will likely vest such that you get an equal amount each month for the remainder of the vesting period. In our example, the remaining 15,000 will vest at a rate of 1/36 for the next 36 months, which comes out to about 416 options vested per month.

How to Calculate What Your Stock Options are Worth

The value of your stock options can be difficult to calculate if the company is not publicly traded. There are a lot of valuation numbers thrown out around what a business stock might be worth, but if there isn’t a monetary event, such as an IPO or a sale of the business, then there isn’t a concrete way to determine what each share price is actually worth.

Some businesses will receive a valuation that you can use to calculate what your stock options might be worth, but these are speculative to a certain degree and shouldn’t be relied on. You will also have to know the number of shares that are available, in all, for the company in order to determine the share price.

If you already know the share price then the calculation becomes easy to make. Every stock option will provide a strike price, which is the value you must purchase your shares at. If your strike price is $10 per share and the current share price is $20 then your shares are worth $10 per share ($20 – $10). Then you can multiply the $10 per share value by the number of share options you’ve been granted and you can come to the total value of your stock options.

How to ExerciseStock Options

Once your options vest, you have the ability to exercise them. This means you can actually buy shares of company stock. Until you exercise, your options do not have any real value.The price that you will pay for those options is set in the contract that you signed when you started. You may hear people refer to this price as the grant price, strike price or exercise price. No matter how well (or poorly) the company does, this price will not change.

Let’s say your four years have elapsed, and you now have 20,000 stock options with an exercise price of $1. In order to exercise all of your options, you would need to pay $20,000 (20,000 x $1). Once you exercise, you own all of the stock, and you’re free to sell it. You can also hold it and hope that the stock price will go up more. Note that you will also have to pay any commissions, fees and taxes that come with exercising and selling your options.

There are also some ways to exercise without having to put up the cash to buy all of your options. For example, you can make an exercise-and-sell transaction. To do this, you will purchase your options and immediately sell them. Rather than having to use your own money to exercise, the brokerage handling the sale will effectively front you the money, using the money made from the sale to cover what it costs you to buy the shares.

Another way to exercise is through the exercise-and-sell-to-cover transaction. With this strategy, you sell just enough shares to cover your purchase of the shares and hold the rest.

Finally, it’s also important to mention that your options do have an expiration date. You can find this in your contract. It’s common for options to expire 10 years from the grant date, or 90 days after you leave the company.

When You Should Exercise Stock Options

When and how you should exercise your stock options will depend on a number of factors. First, you’ll likely want to wait until the company goes public, assuming it will. If you don’t wait, and your company doesn’t go public, your shares may become worth less than you paid – or even worthless.

Second, once your company has its initial public offering (IPO), you’ll want toexercise your options only when the market price of the stock rises above your exercise price. For example, let’s say you have an exercise price of $2 per share. If the market price is $1, it doesn’t make sense to exercise your options just then. You would be better off buying on the market.

On the other hand, if the market price is $3 per share, you would make money from exercising your options and selling. But if the price is on the rise, you may want to wait on exercising your options. Once you exercise them, your money is sunk in those shares. So why not wait until the market price is where you would sell? That way, you’ll buy and sell – and pocket a profit without being out any money for an extended period of time.

That said, if all indicators point to a climbing stock price and you can afford to hold your shares for at least a year, you may want to exercise your options now. That way, you’ll pay less in capital gains tax and on income tax (see below). Also, if your time period to exercise is about to expire, you may want to exercise your options to lock in your discounted price. But if you’re at all worried about losing money, you should consult an investment professional.

Stock Options and Taxes

You will usually need to pay taxes when you exercise or sell stock options. What you pay will depend on what kind of options you have and how long you wait between exercising and selling.

For starters, it’s important to note that there are two types of stock options:

The table below breaks down key tax differences between NQSOs and ISOs:

Taxed as long-term capital gains if shares are sold one year after the exercise date and two years after the grant date. Must pay regular income taxes if sold before then.

Non-Qualified Stock Options (NQSOs) vs.Incentive Stock Options (ISOs)

With NQSOs, the federal government taxes them as regular income. The company granting you the stock will report your income on your W-2. The amount of income reported will depend on the bargain element (also called the compensation element). This is the difference between a stock’s market value and your exercise price.

If you exercise 10,000 options at an exercise price of $1 each, but those shares cost $2 each on the market, the bargain element is $10,000 ($1 price difference x 10,000 shares). That $10,000 goes on your W-2 as ordinary income.

When you decide to sell your shares, you will have to pay taxes based on how long you held them. If you exercise options and then sellthe shares within one year of the exercise date, you will report the transaction as a short-term capital gain. This type of capital gain is subject to the regular federal income tax rates.

If you sell your shares after one year of exercise, the sale falls under the category of long-term capital gains. The taxes on long-term capital gains are lower than the regular rates, which means you could save money on taxes by holding your shares for at least one year.

ISOs operate a bit differently. You do not pay taxes when you exercise ISOs, though the amount of the bargain element may trigger the alternative minimum tax (AMT), which phases out income exemptions targeted for low- and middle-income taxpayers. So if your income is over $73,600 for individuals in 2021 (and more than $114,600 for married couples filing jointly or qualifying widowers, and $57,300 for married tax filers filing separately), you could be subject to the AMT.

When you sell shares from ISO options, you will need to pay taxes on that sale. If you sell the shares as soon as you exercise them, the bargain element is regular income. If you hold the stock for at least one year after exercise AND you don’t sell the shares until at least two years after the grant date, the tax rates you pay are the long-term capital gains rates.

Other Types of Employee Equity Compensation

There are multiple ways that employees can be compensated that are similar to receiving direct stock options. These range from a grant, which provides the right to buy the stock once certain criteria have been met, to full plans that give the right to buy stock to every employee. The main types of employee stock options or ways to purchase stock outside of being awarded options directly are:

The Bottom Line

Stock options are becoming a more common way for companies to attract and keep employees. They’re not as straightforward as a paycheck, but they have the potential of a big payday. Option terms are specific to the individual company through a contract you must sign.You should familiarize yourself with the terms in your contract. It will tell you how many options the company is granting and the length of the vesting period.

The contract will also have the grant price, which is what you will pay when you exercise those options. How and when you exercise options will depend on the price of the shares. There are also income tax considerations, with the promise of lower tax rates if you hold onto your shares for at least one year.

Tips for Selling YourEmployee Stock Options

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