Millennial Series: Part VI (1 of 2) – How Employee Stock Options Work

Posted on Wed, Sep 06, 2017 ©2021 Drucker & Scaccetti

By: Chris Catarino, CPA, MT

 

You just graduated and landed a sweet gig at an internet start-up. There’s no dress code, flexible hours and kegs instead of watercoolers. And that’s not all, they’re giving you employee stock options, too! That’s what CEO’s and company founders get – so that’s, like, better than cash…right? Today, we’ll look closely at employee stock options and, later, in part two of this two-part post, how they are taxed.

 

Whether you receive stock options for the first time at a new job or through a promotion it can be confusing. There’s new vocabulary, a slew of acronyms, and extensive forms written in “legalese.” As part of our Millennial blog series, we’ll explain how some common incentive compensation plans function, the key features, and define all the jargon. And, since we’re Tax Warriors®, we’re giving you the skinny on the tax impact, too! Don’t worry, we’re breaking it into two manageable posts so you can get back to the office ping-pong tournament. 

 

Stock Options – The Basics

 

Employee stock options (“ESOs”) give you (the option holder) the ability to purchase company stock at a set price. That predetermined price is called the “strike price” or the “exercise price.”

 

An option differs from owning a share of stock. To convert your option into shares you must “exercise your option” by paying the strike price. Since you must pay to acquire the stock, an option is worthless unless it is trading above the strike price (i.e., you can sell the stock for more than you pay for it). Also, since employee stock options cannot be traded on the open market, you can’t sell the option. -  You can only sell the stock after you exercise the option.

 

Let’s assume you have an option to purchase 1 share of Apple stock with a strike price of $100.  If Apple stock is trading for $150/share, you can exercise your option by paying $100 to acquire the share, and then sell the share on the open market for $150. Here, you just made $50 and are buying rounds at the bar!

 

When exercising an option, the purchase and sale are often done simultaneously, resulting in immediate cash. This is called a “cashless exercise” since you essentially borrow money from the broker to purchase the shares, and then immediately repay them with the sale proceeds. However, it’s possible to exercise the option and hold the stock if you think it’ going to keep going up in value, although this would likely require a cash outlay.  Hopefully you’re a saver!

 

When the stock is trading higher than the strike price, the option is known as “in the money.” When the stock is trading below the strike price, the option is known as “out-of-the-money” or “underwater.”

 

Using the previous example, if Apple stock was trading at $80/share you could exercise your option by paying $100 for the share, but could only sell it for $80. Since this would cause a $20 loss you would NOT want to exercise the option! Even if you think the stock will go up in the future, you’re better off buying it on the open market at $80/share than paying $100/share by exercising your option.

 

To recap, ESOs are valuable if the company’s stock trades above the strike price, but are worthless if the stock price stays below.

 

Stock Options – Common Features

 

Vesting

 

When employee stock options are given (“granted”) to employees, the strike price is usually at or above the trading price – meaning they have no current value. Additionally, most employee stock options cannot be exercised until a certain amount of time has lapsed. The time from which you are granted the option until when allowed to exercise it is the “vesting period.” This is time when you work your butt-off, cross-your-fingers, and hope the stock price goes up so you can exercise your options and take an extended vacation around the world!

 

Depending on your company’s plan, a portion of your options may vest at different times. For example, if Apple grants you 70 options, each to purchase 1 share of stock at $100/share, 10 may vest after 1 year, 20 options may vest after 2 years and the remaining 40 may vest after 3 years. If Apple stock is trading at $125/share 8 months after your options were granted, you wouldn’t be able to exercise your options and cash in on the $25 of appreciation for each. You must wait another 4 months (until 1 full year had passed) to exercise your first 10 options. Every company’s plan is different and some change plans from year to year, so keep track of when your options vest. Your company can provide you with a vesting schedule with this information.

 

Some plans may even allow you to exercise your options before the stock vests. This can have some nice tax advantages, which will be discussed in our next post.

 

Expiration

 

Another important feature of employee stock options is their expiration date. Just like the milk in the back of your refrigerator, stock options aren’t good forever! Employee stock options are only exercisable for a certain amount of time after being granted. As with vesting, each company and each plan has its own exercise period—10 years is generally the maximum, but it could be less. If an option is not exercised by its expiration date, it is cancelled and you can no longer exercise it. So, if you have in-the-money options, exercise them by the expiration date or you’ll miss an opportunity!

 

Speaking of expiration, that’s about all the blogging we can handle in one sitting. Stay tuned for the next post where you’ll learn how much of that cash you got from exercising your options belongs to Uncle Sam and how much you get to keep.   Meanwhile, contact your financial and tax advisors if you are considering pulling the trigger on your ESOs. Creating a sound plan for your new source of income can save you time, money, and headaches while building wealth for your family.

Topics: wealth, Start-up, Internet, Stock Options, Tax, compensation, retirement, Millennials, ESO, plan, incentive pay, exercise, trade, option, vested, vesting, catarino, strike price

Read & Submit A Comment