What are stock options?

Stock options are a key component of many compensation packages. They let you buy company stock at a set price, which means you can potentially profit if the stock price rises. They can boost your earnings and provide extra incentive to help the company reach its goals.

But how they work and what they really mean for you can be complex to understand, and there are nuances to how they impact your actual total comp. 

Here’s what you need to know. 

What are stock options?

Stock options are financial instruments that give an employee the right, but not the obligation, to buy company shares at a predetermined price (known as the exercise or strike price) within a specified period. They are often part of compensation packages and can provide financial benefits if the company's stock price increases over time.

Key terms to know

The terms associated with stock options aren’t especially common. If it’s your first time navigating this type of compensation, there’s a lot to keep track of.

Here are some key definitions that will help you navigate and make the most of your stock options and equity grants.

Strike/exercise price: The set price at which a stock option can be bought or sold when it is exercised. This price is agreed upon when the option is granted.

Payroll tax: Taxes imposed on employers and employees, typically calculated as a percentage of the salaries that employers pay their staff. For stock options, payroll taxes may apply at the time of exercise.

Capital gains tax: A tax on the profit realized on the sale of a non-inventory asset. The tax is calculated on the difference between the sale price and the original purchase price (cost basis) of the asset.

Market value: The current price at which an asset or service can be bought or sold. For stocks, it's the price at which shares are currently trading on the market.

Stock grant: The allocation of company stock to an employee, often as part of a compensation package. Unlike stock options, stock grants are typically given outright and may come with certain restrictions or vesting periods.

Vesting schedule: A timeline that dictates when an employee earns the right to their stock options or grants. Before vesting, the employee does not fully own the shares.

Incentive Stock Options (ISOs): A type of stock option that can only be offered to employees and provides potential tax benefits. They must adhere to specific rules under the Internal Revenue Code.

Non-Qualified Stock Options (NSOs): Stock options that do not qualify for special tax treatments and can be offered to employees, directors, contractors, and others.

Exercise: The act of buying or selling the underlying stock according to the terms of the option contract.

Grant date: The date on which stock options or grants are awarded to an employee.

Cliff vesting: A type of vesting schedule where the employee receives the full benefit all at once after a specified period.

Graded vesting: A vesting schedule in which portions of the stock options or grants vest incrementally over time.

Fair market value (FMV): The price that an asset would sell for on the open market. FMV is often determined for tax purposes and is important in the context of stock options.

Disqualifying disposition: The sale, exchange, or transfer of stock acquired through an incentive stock option within two years of the grant date or within one year of the exercise date, which can affect tax treatment.

Lock-Up period: A period after an IPO during which major shareholders are restricted from selling their shares. This can affect employees with stock options or grants.

Post-Vesting exercise period: The timeframe after an option has vested during which the employee can exercise the option before it expires.

Alternative minimum tax (AMT): A parallel tax system designed to ensure that high-income individuals pay a minimum amount of tax. Exercising ISOs can trigger AMT liabilities.

Cashless exercise: A method of exercising options where the holder sells enough shares to cover the exercise price and taxes, keeping the remaining shares.

Early exercise: The ability to exercise stock options before they have fully vested, often allowed under certain plans. Unvested shares obtained this way are subject to forfeiture if the employee leaves the company before they vest.

What are the different types of stock options?

There are non-qualified stock options (NSOs) and Incentive stock options (ISOs). It’s up to the company what type of stock option you’re offered.

NSOs

NSOs can be granted to employees, directors, contractors, and others. They do not qualify for special tax treatments under the IRS code. NSOs are more straightforward than ISOs, with the exercise gain taxed as ordinary income, making them easier to manage but potentially resulting in a higher tax burden. Upon exercising NSOs, the difference between the stock's market value and the exercise price is considered ordinary income and is subject to payroll taxes. Any additional gain or loss upon selling the stock is treated as a capital gain or loss.

ISOs

ISOs can only be granted to employees and have favorable tax treatment if specific conditions are met. They are designed to provide incentives for employees to stay with the company and help it grow. ISOs are not subject to payroll taxes at exercise. If the stock is held for more than one year after exercise and two years after the grant date, the gain is taxed as a long-term capital gain. If these holding periods are not met, the gain is taxed as ordinary income.

To qualify for favorable tax treatment, ISOs have to meet the following conditions:

• ISOs can only be granted to employees of the company or its parent or subsidiary.
• The exercise price must be at least equal to the fair market value of the stock at the time of the grant.
• The stock must be held for at least one year after the ISO is exercised.
• The stock must be held for at least two years after the ISO is granted.
• The value of ISOs that become exercisable for the first time in any calendar year cannot exceed $100,000 per employee, based on the fair market value at the grant date. Any amount exceeding this limit is treated as a Non-Qualified Stock Option (NSO).
• ISOs must be exercised within ten years from the date of grant.
• The employee must remain employed from the grant date until at least three months before the ISO is exercised. This period extends to one year if the employee leaves due to disability and is waived if the employee dies.

How do stock options work?

Companies grant stock options to employees as part of their compensation package. The grant specifies the number of options, the exercise price, and the vesting schedule. 

Vesting schedules outline when employees can exercise their stock options. Vesting can occur all at once (cliff vesting) or gradually over time (graded vesting). For example, an employee might receive 25% of their options each year over four years. A common vesting schedule is a one-year cliff (nothing is vested for one year, then 25% is vested all at once), with 25% vested for each additional year, broken down monthly or quarterly.

Once options have vested, employees can exercise them, meaning they purchase the company stock at the exercise price. If the current market price of the stock is higher than the exercise price, employees can buy the stock at a discount.

To exercise options, employees typically notify the company and provide payment for the exercise price. Some companies offer a cashless exercise option, where employees can immediately sell enough shares to cover the exercise price and taxes, keeping the remaining shares.

Stock options vs. RSUs

Stock options and Restricted Stock Units (RSUs) are both forms of equity compensation, but they work differently and offer distinct benefits and drawbacks. 

Stock options give employees the right to purchase company shares at a predetermined price after a specified vesting period. If the company’s stock price rises above the exercise price, stock options can provide significant financial gain, aligning employee and company interests. 

Stock options require an out-of-pocket payment to exercise and may become worthless if the stock price doesn’t increase. Non-Qualified Stock Options (NSOs) are taxed as ordinary income at exercise, while Incentive Stock Options (ISOs) may offer favorable tax treatment but can trigger the Alternative Minimum Tax (AMT).

RSUs grant employees company shares outright upon vesting without requiring a purchase. This guarantees value at vesting, provided the stock has value, and avoids the need for an exercise price, making RSUs simpler and less risky. 

RSUs are taxed as ordinary income when they vest, potentially resulting in higher immediate tax liability. While stock options can offer greater upside potential if the stock price soars, RSUs provide a safer option with guaranteed value at vesting.

The company decides how they are going to grant equity. RSUs are often used post-IPO, and stock options are given at earlier stages because of tax implications. 

The pros and cons of stock options as part of TOC

Stock options can be a highly rewarding component of an employee's TOC but come with inherent risks and complexities that need to be carefully considered. You should weigh the potential financial benefits against the possible drawbacks and seek advice from financial professionals to fully understand the implications.

Here are some benefits and considerations to be aware of.

Benefits:

• Potential for significant financial gain
• Aligns the interests of the company with the employee’s interests
• Employees can be more engaged and interested in company success
• Helps retain top talent

Considerations:

• Employees have to pay an exercise price to purchase shares—not everyone can afford that
• If the stock price doesn’t rise above the exercise price, options may be worthless
• Significant tax implications mean you have to be careful with the choices you make

I was offered stock options as part of my TOC. What questions should I ask?

When offered stock options as part of your compensation, it's important to understand the details and implications this has for you. 

Here are ten key questions to ask the recruiter:

• What type of stock options are being offered? Are they Non-Qualified Stock Options (NSOs) or Incentive Stock Options (ISOs)?
• What is the exercise or strike price?
• What is the vesting schedule?
• What’s the expiration date? How long do I have to exercise the options before they expire?
• Are there specific performance targets or milestones that need to be met for the options to vest?
• How are unvested and vested options treated if I resign, am laid off, or am terminated?
• How will exercising and selling the stock options affect my taxes? Are there any potential alternative minimum tax (AMT) issues with ISOs?
• Can I exercise the options without having to pay the exercise price out-of-pocket?
• Are there blackout periods or other restrictions that prevent me from selling the stock after exercising the options?
• Can I get a copy of the stock option agreement?

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