How do Stock Options Work?

How do stock options work? In this article, we will discuss the different ways in which stock options work. We will look at exercising stock options, vesting, and taxation. Before looking at how stock options work, let us look at what stock options imply.

What are stock options?

Stock options refer to an agreement or contract between two parties that gives the buyer the right to buy or sell stocks or company shares at a predetermined price within a specified period of time. These elective financial assets form a common attribute of the finance world and the stock market. Since stock options are a security’s or an asset’s derivative, they are a form of derivative investment instrument.

What determines the value of the option is the difference between the stock price and the strike price. some organizations provide their employees with stock options as a part of their compensation package. It is in this manner that companies offer derivative stock options and usually give the employee the right to purchase the stock at a specific price for a limited period of time.

Oftentimes, this is a form of encouraging employees to participate in the growth and progress of the company. The employee, in this case, signs a special employee stock option special agreement that details the terms and conditions of the contract when the company grants stock options to them.

Related: Capital Market Instruments, Examples, and Types

Stock options-related terms

  • Call option
  • Put option
  • Strike price
  • Premium
  • Bid price
  • Ask price
  • Vesting date
  • Expiration date
  • Cashless exercise
  • Cashless hold

In order to have a better understanding of what the term “stock option” is all about, these terms will be briefly explained.

Call option

A call option is a financial derivative that gives the option owner the right to buy a stock at a predetermined price during a set time period.

Put option

A put option is a financial derivative that gives the option owner or buyer the right to sell shares of the stock at a set price before or on the expiration date.

Strike price

The strike price is also known as the exercise price or grant price. It is the price at which one can exercise his stock options. The buyer or holder of the option has the right to buy the underlying security at this strike price. One can determine the strike price by taking the current price of the stock and subtracting any premium paid on the contract of the option.

Premium

The term premium refers to the amount the buyer pays for the option. It is a reflection of the maximum profit the seller can make which is a similar case in selling common stock. It also represents the maximum risk for the buyer in put options.

Bid price

Bid price in stock options refers to the price which the buyer of stock options is willing to pay. It is important to have in mind that a stock option contract covers 100 shares of the underlying stock. With this, one has to multiply the bid and stock prices by 100 to arrive at the option contract’s price.

Ask price

Ask price is the price at which sellers of stock options decide, that they are willing to sell their stock options.

Vesting date

The vesting date is the date that one can do something with his grant. Typically, shares vest gradually over a period of time and only the vested shares are exercisable. The contract may also state that one can vest his shares all at one time which can be after an initial period of a few years, known as cliff vesting.

Expiration date

This is the date after which the contract that exists between an employer and employee ends. Oftentimes, the expiration period of stock options can last for as long as ten years. In the United States, the contract for most stock options follows a standard options calendar. Usually, the expiration date is the third Friday of the month that they are set to expire. The holders of stock options have the option of buying or selling shares in accordance with their contract, selling the entire option, or just letting it expire. Once stock options expire, they become worthless.

Cashless exercise

This is not always available but if it is, the holders of stock options can exercise their options and sell them almost immediately. In the cashless exercise, the proceeds of the sale usually go into the brokerage account of the holder so they can reinvest them somewhere else. Also, the holder can have the estimated taxes held at that time. If the market price of the stock is lower than the strike price, then it is best to let the options expire.

Cashless hold

This is a case whereby the stockholder exercises their options and sells enough shares to cover the cost. The remaining shares are then held for investment purposes.

Related: Stock warrants vs Options

How do stock options work?

Just as it is with stocks, stock options can work in or out of one’s favor. As defined above, stock options give someone the right to buy or sell shares of a particular stock at a specified price for a definite period. They are traded on exchanges just like stocks. Each stock option carries an original price and moving forward, the price of stock options can either go up or down.
Many terms and rules exist for stock options and it is important to know the terms for exercising stock options in order to gain an understanding of the process in which they make money and how they lose money. Knowing the rules to prevent problems with the IRS is also important.

How do stock options work?
How do stock options work?

Stock options form part of the underlying stock, with this, their price is tied to the movement of the underlying stock. This means that if the price of the stock goes up or down, the stock options will follow suit.

One of the differences that exist between stocks and stock options is the fact that stock option contracts cover 100 shares of the underlying stock. The buyer’s price and the seller’s price both have an effect on the premium for the option. The intrinsic value is the difference between the strike price of the option and the market price of the underlying stock. Also, the premium is affected by the time that the option expires, and any changes in the price of the underlying stock during the time the option is held.

Two other common terms exist, that one will hear when talking about stock options. These are “in the money” and “out of the money”. Stock options are in the money when the strike price is below the market price. On the other hand, they are out of the money when the strike price is above the market price of the stock.

It is critical to understand these terms because they will be listed in the option agreement. It is, therefore, necessary not to skim over the option agreement, it should be read properly. It is best to consult with a tax or financial professional if there is something that is not understood.

Owning stock options gives one rights and responsibilities with regard to compensation and investing. Owners of stock options need to be aware of how to exercise their options in order for them to make money rather than risk losing it and also to avoid suffering any negative consequences of taxes.

Stock options are designed to be part of an overall financial plan and a financial advisor is the best guide on how one should fit his stock options into his overall investment strategy and financial plan.

Caution needs to be taken when it comes to buying stock options as buying too many is bound to over-allocate the stock option owner to one company’s stock. If the company suffers a decline in its finances and its stock prices drop, an owner will, in most cases, lose a large sum of their net worth. It is for this reason that many financial advisors make use of this phrase, “Do not pull your eggs in one basket”.

Another great thing that a financial advisor can do for owners of stock options is to assist them in committing to an investing strategy. One should be aware that public companies set specified windows where their employees can buy and sell stock as part of their overall financial plan. Also, financial advisors guide their clients on how to account for tax planning in relation to investments.

Related: Stocks and Shares Differences and Similarities

History of stock options

The practice of issuing out stock options to the employees of companies is decades old. The Accounting Principles Board (APB), in 1972, issued opinion No.25, which called for companies to make use of intrinsic value methodology for valuing the stock options granted to company employees.

Under intrinsic value methods used at that time, it was possible for companies to issue at-the-money stock options without keeping a record of any expense on their income statements, as the options were seen to have no initial intrinsic value. In this context, intrinsic value refers to the difference between the grant price and the stock’s market price, which at the time of the grant would be equal. While the practice of not keeping a record of any costs for stock options began long ago, the number being handed out was so small that so many people ignored it.

In 1993, the Internal Revenue Code Section 162m is written and effectively limits the cash compensation of corporate executives to $1 million per year.

At this point, making use of stock options as a form of compensation began to take off. Coinciding with this increase in the granting of options is a raging bull market in equities, to be specific, in technology-related stocks which benefited from innovations that brought about an increase in investor demand.

Sooner, it was not just top executives that were receiving stock options, rank-and-file employees were also receiving as well. At this point, the stock option had gone from a back-room executive favor to a full-on competitive advantage for companies that wish to attract and motivate top talent, especially young talents that did not mind getting a few options that are full of chances such as lottery tickets rather than extra cash come payday.

However, the booming stock market has contributed positively. Instead of lottery tickets, the options that companies granted to employees were as good as gold. This made provision for a key strategic advantage to smaller companies with shallower pockets who could save their cash and simply issue more stock options, all the while not keeping a record of a penny of the transaction as an expense.

How do stock options work when exercising?

Exercising stock options is the act of purchasing shares of a company’s stock at a set price. If one decides to exercise his stock options, it means that he will own a piece of the company. It should be noted that owning stock options is not the same as owning shares outright.

One exercises stock options with the hope that the value of shares will increase so that he can sell them at a higher price, that is the potential positive outcome is that the value of shares being bought is not worth anything.

Exercising stock options can greatly impact one’s taxes. Therefore, speaking to a tax advisor before purchasing any options is recommended. Usually, companies will not allow one to exercise stock options right away. Instead, one has to stay at the company for a certain amount of time, say at least a year, or hit a milestone.

Exercising after vesting

The process of earning the right to exercise the options is called vesting. This will be explained in detail in the latter part of this article. Usually, one can only exercise vested stock options. After one hits his vesting cliff or the waiting period, he should be able to exercise his vested options whenever he desires as long as he remains employed.

Exercising after termination

After one leaves his job, most companies have a 90-day post-termination exercise period (PTEP), when he can still purchase his shares.

After this period, one will no longer be able to exercise his options, this means that they will go back to the company’s employee option pool. There are companies that offer more PTE periods and some, for as long as the employee works with the company.

Exercising stock options early

There are companies that will allow the employee to exercise stock options early before they vest. If a company allows this, one can exercise his options as soon as he gets his option grant, however, they will continue to vest in accordance with the original schedule.

Benefits of exercising stock options early

  • One of the benefits of early exercise is the favorable tax treatment for ISOs. To qualify for this, one has to keep his shares for at least two years after the option grant date and one year after exercising.
  • For NSOs, there will be a lower holding time. In other words, early exercise helps one to start his holding period sooner in order to pay the lower long-term capital gains tax after the sale.
  • There is a likelihood for the holder not to owe additional taxes. This means that if one exercises his options early as soon as they are granted, at the time of exercise, he is buying them at fair market value. This assumes that no spread exists between the current worth of the stock and the amount paid.

It is important to note that in order to take advantage of this potentially favorable tax treatment, one has to file an 83(b) election within 30 days of exercising. There could be no serious ramifications if one misses this deadline.

Risks of exercising stock options early

  • The options holder has to make use of his own money. When exercising early it is not possible for one to sell his stock in order to pay for his shares.
  • There is no guarantee that there will be an increase in the value of one’s shares. By waiting for the usual one-year vesting cliff, one may get a better idea of whether to purchase his options or not.
  • It is important to have in mind that if an option grant is early exercisable, one may trigger the $100,000 rule. This prevents one from treating more than 100k of the full value of his grant as incentive stock options (ISOs) in the year the grant was received. For tax purposes, the value of the options grant above that amount is treated as nonqualified stock options (NSOs).
  • If an employee leaves his company after early exercising but before his stock vests, his option grant usually gives the company the right to repurchase his early-exercised, yet unvested stock.

How to exercise stock options

  • Pay cash (exercise and hold)
  • Cashless (exercise and sell to cover)
  • Cashless (exercise and sell)

The ways in which one can exercise his stock options vary across companies. These ways are explained below.

Pay cash (exercise and hold)

This way, one uses his own money to buy his shares and keep all of them. This method is the riskiest because making a profit is not guaranteed. Another risk factor is that one’s money is tied up to his shares until he sells. However, it could pay off if one’s shares end up being worth a lot. However, this gives one the maximum investment in company stock thereby providing the potential for gains from increases in the value of stock and dividend payments if any. There may be a need for one to deposit cash into his brokerage account or borrow on margin to pay for shares. There is also a likelihood to pay brokerage commissions, fees, and taxes.

Cashless (exercise and sell to cover)

If an employee’s company is public or offering a tender offer, they may allow him to simultaneously exercise his options and sell enough of his shares to cover the purchase price and applicable fees and taxes. Here, the employee can do whatever he wants to do with the remaining shares, either to keep the rest or sell some.

Cashless (exercise and sell)

If one’s company is public or offering a tender offer, they may allow one to exercise and sell all his options in a single transaction. Some of the money from the sales covers the purchase price and applicable fees and taxes, and one pockets the rest of the money. In most cases, one’s brokerage will allow this transaction without one using his cash, with the proceeds from the stock sale covering the purchase price, and the commissions, fees, and taxes that are associated with the transaction. This stock makes provision for cash in one’s pocket to put into other investments or use as otherwise seen fit.

Stock swaps

A stock swap is another form of cashless exercise of stock options. With this, one exchanges already owned company shares to pay for the shares obtained through the exercise of the stock option. The main benefit of this choice is tax avoidance. However, one should have in mind that he must hold the shares used in the exchange for a stipulated period of time, typically one or two years, in order to avoid the transaction being treated as a sale and also incurring tax costs.

Factors to be considered while exercising stock options

  • Current financial status
  • Prevailing market trends
  • Taxes and financial planning

These are some factors that will help one in deciding how and when to exercise his stock options.

Current financial status

If an employee requires a high cash amount and his stock options have a positive value, then he can exercise his options. This can be of help particularly if one has a high loan amount to repay or if he requires to make a down payment. He can also exercise them during other unexpected emergencies such as a medical emergency. Also, if one is pursuing higher education or has to relocate, he can consider exercising his stock options to have higher availability of capital.

Prevailing marketing trends

If one thinks that investing in another stock can be more profitable, he can exercise his stock options and reinvest the capital. Exercising stock options can also be important to maximize one’s profit or minimize loss if the company is performing poorly and one has no confidence that its performance can improve in the ‘future. It is also okay to consider macroeconomic trends in the economy to evaluate the volatility in the stock market. If a crash is about to happen, one can exercise his options and diversify his investment to minimize the impact.

Taxes and financial planning

The gains from selling company stock can bring about an increase in one’s tax liability. By making plans regarding projected income and deductions in the future, one can choose the right time to exercise his stock options. For instance, if one exercises all his options together, there may be a significant increase in his tax liability in that particular year.

Consulting a financial planner or accountant to identify the right time to exercise employee stock options is critical to ensuring maximum profit and minimum tax liability. Also. doing so will help determine how to reinvest or manage capital smartly.

How do stock options work when vesting?

The vesting period of stock options refers to the timeframe during which an employee has the right to earn the options. This implies that one does not get to own all the options at once, they are rather earned over a period of time. The purpose of this is to keep the employee working for the company for as long as possible using the options vesting as a lure. The more the number of years, the more options the employee earns.

Usually, the company sets timelines over a period of time known as the vesting schedule. This reveals the number of years it will take one to work with a company in order to earn the options. Also, companies make use of targets to set vesting schedules and these could be achievements, milestones, time-based targets, or a combination of time and milestones.

Milestone-based vesting can an employee the privilege to quickly earn options as long as it is possible to achieve the milestones earlier. This gives one control compared to time-based vesting where one has to stay with a company for a required number of years.

Related: Advisory Shares Meaning and Example

How do stock options work in terms of taxes?

Two common types of stock options exist, these are incentive stock options (ISOs) and nonqualified stock options (NSOs), also known as non-statutory stock options. The major difference that exists between them is how they are taxed.

How nonqualified stock options work

With NSOs, one realizes ordinary income when he exercises his options, on the basis of the difference between the fair market value (FMV) and the exercise price. When all shares are sold, any additional gain is taxed as capital gains or losses.

Nonqualified stock options are generally subject to greater tax liabilities compared to incentive stock options because they are taxed on two separate occasions, that is upon exercise and when the shares of the company are sold. Another reason is the fact that income tax rates are generally higher than long-term capital gains tax rates.

Income tax upon exercise

When one exercises NSOs and opts to purchase the shares of a company, the difference between the share market price and the strike price is referred to as the bargain element. The bargain element is taxed as compensation and this implies that one will need to pay ordinary income tax on that amount.

Aside from owing federal and state income taxes, one will also be responsible for Medicare and Social Security taxes as well. The company or employer usually will help in facilitating tax withholding and may offer the choice of paying taxes using cash or reducing the number o company shares received in order to cover the taxes that are due.

Capital gains tax upon stock sales

Added to the payment of income taxes upon exercise, any gains that are accrued when the sale of company shares takes place will be subject to capital gains tax. Depending on the length of time one holds his company shares post-exercise, he will be responsible for either long-term or short-term capital gains taxes.

Since short-term capital gains are taxed higher than long-term capital gains, it may be sensible to hold onto the shares for more than one year. If possible, one can qualify for long-term capital gains tax rates. This will be helpful in minimizing one’s overall tax burden since there is already a need to foot the bill for income taxes.

Paying attention to tax consequences is very important as it helps one in planning what to do with his NSOs.

How incentive stock options work

On the other hand, ISOs are not taxed as income right at exercise. Rather, the difference between the strike price and the exercise price may bring about the alternative minimum tax (AMT) to apply if one holds the shares past year-end. When the shares are sold, they are taxed at long-term or short-term capital gains depending on the length of time they are held after exercise. For long-term capital gains treatment, one must hold the shares more than two years after the grant and more than one year after exercise. If one sells the shares before either of these holding periods is met, they receive short-term capital gains treatment.

In other words, for one to get tax benefits for incentive stock options when it is exercised, the shares have to be held for more than two years from the grant date and one year from the exercise date of the options. This implies that one is not taxed when he meets these criteria. However, when one sells the stocks, the income is taxed at the long-term capital gains tax rate which is lower compared to regular income tax rates.

If one decides to sell the stocks that were exercised, the difference between the current stock price and the exercise price will be taxed as capital gains. However, capital gains tax applies to both ISO and NSO stock options. This is because one now has ownership of the stock when options are exercised. Therefore, selling them is just like selling assets, of which any profit generated from selling assets would be taxed as a capital gain.

The capital gains tax rate for most assets that are held for more than one year is about 0% to 20% while the tax rate of ordinary income is about 10% to 37% depending on the income bracket. This shows that the tax rate for capital gains is lower than the rate of ordinary income. It also shows that one gets more tax benefits when he optimizes for capital gains.

This implies that one can benefit from lower tax liabilities by maximizing long-term capital gains tax treatment. The lower the difference between one’s exercise price and the stock price when the options are exercised, the more the tax benefit that will be derived from capital gains tax treatment. When one exercises stock options and sells them within a year, the income will be taxed as a short-term capital gain of which the tax rate is higher than the long-term capital gains tax rate.

Disqualifying disposition of ISO

When one sells stocks from the exercise of his incentive stock options in the same year of exercise, it means that the stock options have been disqualified. Any income generated from the sale would be taxed as a regular income tax for that year. In this case, the tax would be calculated on the basis of the lesser of the spread which is the difference between the exercise price and the stock price of the shares at the time the exercise or disposition took place.

Example of disqualifying disposition of ISO when the stock price is lower than the strike price

Assuming the exercise price is $5 and the price of the stock at the time the options were exercised is $25, the difference which is the spread will be $25 – $5 = $20. If for example, 1,000 ISO shares were exercised and then later disqualified at the time when the price of the stock has fallen to $15, it means that the amount of income that will be taxed at a regular income tax rate will be ($15 – $5) X 1,000 = $10,000.

Example of disqualifying disposition of ISO when the stock price is higher than the strike price

Let us assume the holder disqualifies when the stock price is $35, it implies the lower exercise price of $25 will be used to calculate his income tax. This implies that the income that will be charged will be $25 – $5 = $20 x 1,000 shares = $20,000. The income remaining from the excess of $10 per share will be treated as capital gain, and when it is held for more than a year, it will be taxed as a long-term capital gain. If on the other hand, it is held for less than a year, it will be taxed as a short-term capital gain.

A disqualifying disposition of incentive stock options below the market value at the time of the exercise of the options will cause one to lose the capital invested with no ordinary income tax.

It should be noted that tax treatment for stock options can be complex, and how and when one decides to exercise and sell will greatly be dependent on the unique situation.

Alternative minimum tax (AMT) for ISO stock options

The AMT refers to a system of taxation that ensures that every individual pays the right amount of income tax, especially high-income earners. Usually, there is an alternative minimum tax amount below which one is not taxed, but above which one will be taxed.

When one earns more than the AMT amount, it is necessary to calculate the tax for one’s ordinary income, and also for AMT, the higher amount will then be paid as tax.

For ISOs, if one exercises and sells the options within one year, the AMT will not be applicable to one’s income. If on the other hand, one exercises his ISO and holds them for more than one year before selling the stocks, there will be a need to calculate the AMT amount and then compare it to one’s income from the sale of the stocks. The one that is higher will be taxed as ordinary income. Here, one determines the stock options value by subtracting the strike price from the current stock price or simply the difference between the two.

Example

Assuming an employee was granted 600 incentive stock options at $2 and then he exercises the options two months after they were granted. 14 months after the exercise of the options, the stock price then became $12 and they were sold. From this information, the value of the stock options will be stock price minus strike price, which is $12 – $2 = $10. When we multiply it by the number of options exercised, it will be 10 x 600 = $6,000

This figure, $6,000, will then be added to the holder’s ordinary income and used for calculating the AMT. It is important to note that if the current market value of stocks is greater than the strike price, then the difference will be taxed as ordinary income (as previously stated), regardless of whether the stocks are sold or not. Holding the stocks without selling them may bring about continuous accumulation of taxes and an increase in one’s tax liability. The case becomes worst when the stock price fall. This shows that early exercise of stock options may increase one’s tax liability.

There is a need for companies to file the IRS Form 3921 whenever any employee exercises an ISO.

Related: ISO vs NSO – Which is Better?

How do stock options work in a private company?

Stock options in private companies are just the same way they do in public companies. The exemption is the fact that when the employee exercises the options, it is not possible to publicly trade the shares they receive.

One basic reason why companies issue stock options is the fact that they are not considered business expenses on the books of account. Small companies such as private corporations usually do not have the financial size to offer high-performing employees salaries that are equal to their large, publicly traded corporate peers. They try to attract and keep employees through all means which includes giving them greater responsibility, flexibility, and visibility. The act of issuing stock options is an additional way. Private companies may also pay vendors and consultants using stock options.

A private company, just like other companies, needs to conserve cash. Therefore, it can pay its consultants and vendors with stock options. However, not all vendors and consultants receive stock options as payment, but those who receive stock options as payment can save a company a significant amount of cash in the short term. Generally, stock options used to pay for goods and services do not have vesting requirements.

Employees receive stock options that give them the right to buy shares at a later date for a strike price. The vesting period which is the time over which the employee earns the right to exercise those options is usually determined by the amount of time the employee remains at the company. In the United States, if the stock options are incentive stock options, then there is no tax event to the employee when they are exercised.

However, there will be a need for the gain at exercise to be reported for alternative minimum tax (AMT) purposes. If the stock options are nonqualified (NSOs), the employee will need to pay taxes on the gain, that is the difference between the value of the stock at exercise and the exercise price, at the time the exercise took place. As this is considered W2 income, sometimes, employers will withhold this amount from payroll, otherwise, there may be a need for the employee to pay the exercise price and taxes to the company directly.

The options will be restricted once they are exercised. The opportunities that one has for liquidity are dependent on the company. In some cases, one may have to hold them until an initial public offer (IPO) or company sale. There are cases in which the company will provide opportunities for liquidity by carrying out periodic share repurchases or allowing some controlled trading. It is not the case that all the shares of private companies can be sold on the secondary market, this depends on the rules and restrictions of the company. In this case, the plan documents, grant agreements, and shareholder’s agreements that have to do with the award should provide more information.

Common types of private stock options

  • Qualified small business stock
  • Long-term capital gains
  • Unexercised incentive stock options
  • Unexercised non-qualified stock options
  • Restricted stock units

According to the tech-focused wealth planning firm KB Financial Advisors, there are generally five types of stock options that are available through a private company. Each of these types of options comes with risks just as they come with potential benefits. These five options are explained below.

Qualified small business stock

These are considered “founder shares”, they are less risky compared to other types of options. The PATH Act has made it possible to exclude capital gains up to $10 million or ten times the adjusted basis, whichever is greater. For the holder to realize these benefits, it is mandatory for the stocks to be held for five years.

Long-term capital gains

Long-term capital gains must be held for at least one year. They are subject to capital gains taxes as well as realized capital losses and wash sale rules.

Unexercised incentive stock options

This is the option to buy the stock at a lower rate for employees without regular income tax at exercise.

Unexercised non-qualified stock options

Similar to an unexercised incentive stock option with the option to buy the stock at a lower rate for employees. The exception is that there is income tax assessed on profits.

Restricted stock units

Restricted stock units are issued to employees as payment, typically on a vesting schedule, and taxes are due at vesting.

How do stock options work for a startup?

The act of making employees sign off on a stock option agreement gives them the flexibility that is much needed when it comes to offering salaries and other financial aspects. If stock option plans are used correctly, they have the capability to contribute capital to startups as it is necessary for employees to pay for their option’s exercise price.

However, entrepreneurs enduring a disadvantage when they issue stock options in a startup is inevitable. This disadvantage is the potential dilution of equity that belongs to other shareholders once the employees exercise their stock options. The only disadvantage associated with stock options that employees could face is the absence of liquidity. The stock options will not equal cash benefits unless the company forms a public market that is dedicated to its stocks.

Another thing to understand is that if the company fails to grow, there will be no increase in the value of its stocks thereby making the options worthless. However, it is fortunate that there have been very few cases where massive losses have been faced by people. In fact, a large number of people ended up earning millions of dollars, this proves that startup stock options can be profitable in the long run.

Facebook as the social media giant is a remarkable example that showcases the reasons why stock options are so appealing to employees.

For example, the remarkable success of startups in Silicon Valley alongside the economic growth of employees who opted for stock options is proof that it is possible for startups can indeed achieve both short-and long-term success by making stock options an integral part of their compensation packages.

There is a need for startups to address several issues before implementing a stock option plan. In most cases, it is the desire of companies to incorporate a plan that makes provision for maximum flexibility.

Related: ISO vs NSO Differences and Similarities

How the stock option agreement works

A stock option agreement is a contract that exists between a company and an employee which is used as a form of employee compensation. Both parties submit to operate within the terms, conditions, and restrictions that are stated in the agreement. The party that receives the stock options is a highly esteemed employee that will earn the right to exercise them. Also, the employee will gain the right to purchase the stock options at a predetermined price. A stock option agreement states the rights of the employee.

It is always advisable that employees negotiate the stock options before signing the agreement. Oftentimes, employees tend to feel inadequate in cases whereby negotiations about stocks and salary are concerned. However, it is possible for one to arrange his stock option agreement before signing it. One should put into consideration a background review of all dynamics around the offer when negotiating. Research should be conducted to ensure that one has knowledgeable information about the key terms to negotiate.

Terms contained in the stock option agreement

  • Parties to the agreement
  • Stock option shares
  • Exercise price
  • Total exercise price
  • Effective date
  • Conditions to exercise
  • Expiry date

The stock option agreement contains specific terms that should be known as listed above. These terms help in determining the scope and extent of the contract.

Parties to the agreement

The first thing that the agreement lays down is the parties to the contract. The parties are usually the company issuing the stock options and the employee receiving the stock options. The contract may make reference to the employee as the optionee and the company as the optionor.

Stock option shares

The amount of the option shares refers to the company shares that the employee will have the right to buy in the future. In the agreement, the number of options issued to the employee is stated.

Exercise price

Another term contained in the stock option agreement is the exercise price. As earlier stated, it is the price at which the optionee has the right to purchase the shares. Also known as the strike price, this is the fair market value of the company’s stock at the time of issuance.

Total exercise price

The total exercise price that is outlined for the employee is also stated in the stock option agreement. If the employee were to buy all the options, then he will have to pay the total exercise price to the company.

Effective date

The effective date is another common term that is contained in the stock option agreement. This is the period within which the stock option becomes effective. For instance, the effective date may be that day on which the optionee signs the stock option agreement.

Conditions to exercise

This clause gives clarity regarding the conditions that must be met before the stock option becomes effective. While the commercial objective of the optionee often determines the conditions to exercise, they are not necessary. For example, another condition can be the time which comes in the form of a vesting schedule.

Expiry date

The expiry date is another critical term that is contained in the stock option agreement. It is on this date that the agreement often terminates. The parties involved discuss the expiry date when entering into a stock option agreement. However, the actualization of this date may be determined by different circumstances.

RSU vs stock options differences

Restricted stock units (RSUs) and stock options are taxed differently. As soon as Restricted stock units or RSUs become vested and liquid, they become taxable. It is a common thing for companies to withhold some restricted stock units to pay taxes that will be owed when they are vested.

A company may also give its employees the option of paying taxes with cash to enable them to retain all vested RSUs. This consideration is crucial because the taxes can be high depending on the circumstances. Between federal and state taxes, the rate can be as high as 48% which depends on the state the holder lives in and the value of his RSUs.

On the other hand, stock options are not taxed until they are exercised, Employees that exercise their options prior to the time that the value of options increases and file an 83(b) election will not have to pay taxes until they sell the options. As earlier stated, employees that choose to hold their options for at least a year after exercise will be taxed at the capital gains rate.

Approximately, the taxable gains rate is approximately 12% less than regular income tax rates. There may be a need for employees to pay an AMT if they exercise their options after they have increased in value but before they are liquid.

To know more about the differences between restricted stock units and stock options, see Stock Options vs RSU Differences and Similarities.

Last Updated on November 8, 2023 by Nansel Nanzip Bongdap

5+ years of professional experience in the business and finance sector with 1 year experience as a sales associate.
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