How To Completely Master Your Equity Compensation: A Guide To Stock Options
Many companies these days are looking past the typical forms of employee compensation.
In a highly competitive job market, high salaries, promising bonuses, and a 401k match might not be enough to attract and retain top-tier talent. Stock options are a popular form of compensation in the start-up space that offer employees the option to purchase company stock at a predetermined price.
Unlike Restricted Stock Units (RSUs), stock options do not convert to shares automatically on the day they vest. Stock options give you the right (or opportunity) to purchase your company stock at a predetermined exercise price on or after the vesting date. In an ideal scenario, the exercise price will be much lower than the current market value on the vesting date so that you can purchase the stock at a significant discount.
When used correctly, stock options can play a significant role in your overall compensation package. You must understand the basic tenets of stock options, the different types of options available, and the strategies needed to effectively integrate them into your overall financial plan.
Common Stock Options Terms Explained
There is nearly no topic in finance more peppered with jargon than stock option planning. It is certainly no small task to fully understand how stock options work. Let’s clear things up and get some basic terms on the table.
- Grant Date: The day your company gives you the stock options and associated terms. This is the date on which you will be given information regarding the number of shares, exercise price, vesting schedule, vesting date, and offering period (all discussed below).
- Exercise Price/Strike Price: The predetermined price that you can buy your company’s stock in the future. For example, you may have an exercise price of $50 on 100 shares with hopes that your company will be worth much more in the future.
- Vesting Schedule: The time it takes for your options to be available for you to exercise (or purchase). Using the 100 share example, it’s common for your shares to vest evenly for four years (i.e., 25 shares per year for 4 years). Structuring it like this incentivizes employees to stay with the company for more extended periods.
- Vesting Dates: These are the specific dates in which your shares vest and become available to purchase. For example, your shares may vest on March 1st of every year for the next 4 years.
- Offering Period: This is the amount of time an employee has to exercise options. A common period would be 10 years after the vesting date. In other words, you would have the right to purchase your company stock at the predetermined exercise price for the 10 years following a specific vesting date.
- The Spread: The difference between the current fair market value and the exercise price. Your options are said to be “underwater” if the current market value is less than the exercise price. Conversely, your options are “in the money” if the current market value is greater than the exercise price.
As you may have already noticed, there is one critical thing to note regarding employee stock options.
You need funds to purchase your options.
If you would like to exercise 25 shares of company stock at $50 per share, you would need $1,250 available to make the purchase. Employees typically use their own funds to exercise shares or utilize a cashless exercise (although the latter will require you to sell your shares immediately and could forgo some potential tax incentives associated with holding the shares long-term).
ISOs and NSOs—What They Are and How They’re Taxed
Now that we have reviewed the common terms associated with employee stock options, we can jump into the two major types of options, how they work, and their associated tax implications.
Non-Qualified Stock Options (NSOs)
NSOs have two taxable moments:
- On the exercise date (ordinary income tax on the spread)
- At the point of sale (ordinary income tax or capital gains rates depending on the holding period).
The easiest way to get the hang of things is to review a simple example.
Ordinary Income Tax: On March 1st of this year, 25 of your 100 company shares vest, and you can exercise the options at a strike price of $50 per share. On this date, the stock’s fair market value is $75 per share, and you decide it’s a good time to exercise the options for $1,250 ($50 x 25). All of the sudden, you have a stock worth $1,875 ($75 x 25) and have made a profit of $625 ($1,875 – $1,250). You will now owe ordinary income tax on the $625 profit.
Long Term Capital Gains Tax: Continuing with the above example, let’s assume you held your 25 shares for over 1 year and then sold them at $95 per share. You now have an additional profit of $500 ($95/share – $75/share = $20 gain/share on 25 shares = $500 profit). Because you held the stock for over 1 year, you will only owe capital gains tax on the $500 (as opposed to the higher ordinary income rates for stock held less than 1 year).
NSOs are extremely flexible for employers and can be given to employees, contractors, vendors, and those not on payroll.
Incentive Stock Options (ISOs)
Unlike NSOs, ISO’s are far more restrictive and have some unique properties. For starters, ISOs are only available to employees and have a $100k per year limit for each employee. They are also required to have a 10 year offer period.
While ISOs may seem like a complete headache, their tax benefits make them worthwhile. There are three different types of tax you’ll need to consider. Let’s continue with our example from the NSO section.
Ordinary Income Tax: You can actually avoid paying ordinary income taxes on ISOs entirely if you follow two specific rules:
- Hold the stock for more than 1 year after you exercise.
- Hold the stock for more than 2 years after the initial grant date.
Long Term Capital Gains Tax: Your entire gain will be taxed at a capital gains rate if you satisfy the requirements above. In our example, that would be $1,125 at those lower tax rates ($95/share – $50/share = $45 gain/share on 25 shares = $1,125 profit).
Alternative Minimum Tax (AMT): It is important to note that the spread between the fair market value and the exercise price will count as income for calculating AMT. AMT is a secondary tax system for high-income earners that is intended to put a floor on the amount of taxes paid. The concept is too in-depth to discuss within this post, but it is nonetheless an important consideration regarding ISOs.
Your Options Are Exercised, Now What?
Even after you understand NSOs and ISOs, how they function, and their tax implications, you still have some important considerations related to your overall financial situation.
- Should You Exercise Your Shares?: It may seem obvious to exercise your shares for a profit the moment you are eligible to do so. Before moving forward, consider the tax implications. Will your ISOs trigger AMT? If so, at what level of profit? Does it make sense to wait until next year when you have a reduction in income?
- Should You Sell Your Exercised Shares?: This will depend on your other assets and financial situation. What percentage of your assets are in your company stock? Can you afford short-term fluctuations in the market price? Do you believe in the long-term growth of the organization?
- What Should You Do With The Proceeds?: Again, it depends. Do you have short-term goals (i.e. emergency fund, dream vacation, home down payment, etc.)? Do you want to invest the proceeds in a more diversified fashion? Are you charitably inclined? If so, there are some tax-efficient ways to donate before you sell the stock.
The world of employee stock compensation is a complex one. In many cases, there are thousands of dollars at stake, and you simply can’t afford to make a mistake. Schedule an introductory phone call with our team today and allow us to help you manage the complexities of employee stock options.