Understanding Your Employee Stock Options

Many companies issue stock options to their employees. When used correctly, these options can be of great value to you.

Basics of Employee Stock Options

With an employee stock option plan, you are given the right to purchase a specified number of shares of the company at a fixed price known as the “exercise price” (or “strike price”), over a specified number of years.

Your options have a vesting date and an expiration date. You cannot exercise your options before the vesting date or after the expiration date.

Your options are said to be “in the money” when the current market price of the stock is higher than the exercise price.

Here is a summary of the terms you will find in your stock option plan:

• Exercise Price/Strike Price: The fixed price at which you can purchase shares according to your stock option plan.
• Grant Date: The date the option is granted to you.
• Market Price: The current price of the stock.
• Vesting Date: The date when you can exercise your options according to the terms of your stock option plan.
• Exercise Date: The date you exercise your options.
• Expiration Date: The date by which you must exercise your options before they expire.

How It Works

To understand how an employee stock option plan works, let’s take a look at an example.

Suppose that on January 1, 2019, you are granted employee stock options giving you the right to purchase 1,000 shares of Widget Company at a price of $10.00 per share. You must do this by January 1, 2029. On Valentine’s Day in 2024, Widget’s stock price reaches $20.00 per share, and you decide to exercise your stock options. At this point:

• Your exercise price is $10.00 per share.
• The current market price is $20.00 per share.
• The grant date is January 1, 2019.
• The exercise date is February 14, 2024.
• The expiration date is January 1, 2029.

To exercise your stock options, you need to purchase the shares for $10,000 (1,000 shares × $10.00 per share). You can do this in several ways:

• Cash Payment: You can send $10,000 to the brokerage firm handling the options process, and you will receive 1,000 shares of Widget. You can hold the stock or sell it.
• Cashless Exercise: You can exercise your options and sell enough shares to cover the purchase price. The brokerage firm will handle this simultaneously. You will end up with 500 shares of Widget, which you can keep or sell.
• Stock Swap: You can send in a certificate for 500 shares of Widget, which equals $10,000 at the current market price, and this will be used to purchase 1,000 shares at a price of $10.00 per share. You will end up with a total of 1,000 shares of Widget, which you can keep or sell.

Types of Options

There are two types of stock options that companies issue to their employees:

• NQs: Non-qualified stock options
• ISOs: Incentive stock options

Different tax rules apply to each type of option. In the case of non-qualified stock options, taxes are generally withheld from your income at the time you exercise the options. This is not necessarily the case for incentive stock options. With proper tax planning, you can minimize the tax impact when exercising your options.

Your stock option plan will contain a document outlining the rules that apply to your options. Get a copy of this document and read it, or consult a financial planner who is familiar with these types of plans to assist you.

There are many factors to consider when deciding whether to exercise your options. Investment risk, tax planning, and market volatility are some of these factors, but the most important factor is your personal financial circumstances, which may differ from those of your coworkers. Keep this in mind before following any advice.

Should You Hold the Shares?

Holding a large amount of company stock is risky. When your income and a large part of your net worth depend on a single company, if something bad happens to the company, your financial security could be at risk. Executives should take this into account in their planning and work to diversify their investments outside of company stock.

Questions

The Exchange

How is taxation applied to employee stock options?

The way taxation is applied to incentive stock options differs from how it is applied to non-qualified stock options. In the case of non-qualified stock options, the difference between the exercise price and the fair market value is deducted as ordinary income in the year the option is exercised. When you sell the stocks, any gain in the selling price is subject to capital gains tax. In the case of incentive stock options, there is no tax at the time of exercising the options unless you are subject to the alternative minimum tax (AMT). Those with incentive stock options will pay taxes when they sell the stocks later on the difference between the exercise price and the selling price.

What happens to stock options upon company acquisition?

What happens to stock options during a company acquisition depends on the specifics of each acquisition. If your options have vested, you may be able to exercise any options that are “in the money.” Alternatively, the acquiring company may replace your options with their own stock options. If your options have not vested, they may be canceled or their vesting may be accelerated. It all depends on the terms of the acquisition.

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Sources:

• U.S. Securities and Exchange Commission. “Employee Stock Option Plans.”
• Fidelity Investments. “Introduction to Options – The Basics.” Page 22.
• Internal Revenue Service. “Topic No. 427 – Stock Options.”
• American Financial Industry Regulatory Authority. “The Reality of Investment Risks.”

Source: https://www.thebalancemoney.com/understanding-your-employee-stock-options-2388513