Employee stock options (ESOs) are becoming a more prevalent form of compensation, especially among technology companies and startups. They allow workers to purchase company stock at a given price, often lower than the current market price. Workers benefit financially if the company does well, and employers utilize stock options as a form of retaining and attracting talent. However, there are subtleties of ESOs that need to be understood in an attempt to unleash their highest potential and avoid financial mistakes. This ultimate guide dissects what you need to know about employee stock options.
What Are Employee Stock Options?
They are a type of compensation given to employees. It gives them the right to buy company shares at a fixed price after a specific period. It allows employees to profit if the company’s stock value increases.
A sample vesting schedule could be a four-year plan with one-year cliff vesting 25% of your options in the first year and 75% of the rest of your options over the next three years. Stock options attract, retain, and motivate employees.
Types of Stock Options: ISOs vs. NSOs
There are two broad categories of employment stock options: non-qualified stock options (NSOs) and incentive stock options (ISOs). ISOs are generally reserved for employees and are tax-favored, but with limited conditions. NSOs can be issued to consultants, advisors, or board members and have unique tax consequences.
The main difference lies in taxation. ISOs are not subjected to any tax bite if exercised under; nonetheless, they may fall under the Alternative Minimum Tax (AMT) regime. NSOs are taxed as ordinary income on exercise, depending on the strike price and fair market value difference.
Funding the Exercise of Your Stock Options
Exercise of stock options generally is a cost, particularly in startups where it may involve a high strike price or the company has issued a high number of options. Funding this expense may be difficult, and staff members need to consider assets and equipment available for funding the acquisition.
Some of the popular ways to pay for startup stocks include using your own money, taking a loan, or taking the cashless option, where you sell half of the shares first to finance it. Each strategy has varying implications. With your own money, you have total ownership of the shares, but you put your cash at risk. Loans will allow liquidity at the time it is needed, but they involve interest and payback times to be taken into account.
Exercising Stock Options
Exercising your stock option means purchasing the company’s shares at the strike price. If the current market value is higher than your strike price, you’re buying at a discount. However, exercising requires cash upfront and may have tax implications.
You have to choose when to exercise: early, at work, or after leaving. Exercising early may minimize tax exposure, but it risks the stock falling or losing value. Always consult a tax planner or financial professional before exercising options to suit your financial objectives.
What If You Leave the Firm?
If you do leave a company, you typically have a relatively short period, 90 days, in which to exercise vested stock options. If you do not exercise them within that time, you may lose them. This situation is financially stressful, particularly when exercise prices are high.
Some companies, especially forward-thinking startups, extend exercise windows to 10 years or more. It is essential to know your firm’s policy. Find the cost of exercising and discuss it with a financial advisor before resigning to see if it is financially worthwhile based on your own and career goals.
Tax Implications of Stock Options
Employee axes are the most complicated part of employee stock options. With ISOs, you can receive long-term capital gains tax rates if the holding periods are met. That is two years from the date of the grant and one year from the date of exercise. If they are not met, gains will be considered ordinary income.
NSOs are less tax-favored but easier. When you exercise NSOs, you tax as ordinary income the excess of fair market value over the exercise price. Any profit on the later sale of the shares is capital gain. Proper planning can minimize tax liability, so it pays to be aware of your tax exposure.
Exit Events and Liquidity Opportunities
The end game of stock options is to profit from an exit event like an IPO or acquisition, when you can sell for a gain. Vested options are worth more at this time. Timing is everything: if you haven’t exercised your options prior to the event, you might be forced to act fast.
In startups, liquidity events are rare, and sales of shares in secondary markets usually are not allowed. Tender offers or company-backed buyback plans where you can cash out may be offered in some startups. Always keep yourself updated on possible liquidity events and company guidelines so that you can act when the time comes.
Endnote
Employee stock options present an exceptional opportunity to share in the success of your company. Make your experience great by knowing everything from the types of stock options to the exit plans. Being knowledgeable will not only help you make the right decisions but also guide you to long-term financial growth.