Stock Options 101 (for Employees)

By October 29, 2018Financing
using mobile phone to check stock price

If you’ve ever thought about working for a startup, then you’ve likely heard of stock options (perhaps along with stories about people who “got rich” because they had some). Stock options are a big deal for startups, and they can be worth a lot of money if a company does well. This article will give you the basics of stock options from an employee’s perspective: what they are, why they are used, and how they work, so that you can be more informed about how stock options may impact you. For more information about the technical details of stock option dilution and other issues relevant to employers, see our article Dilution and Stock Option Pools.

What are stock options?

Before you can understand what a stock option is, you need to have a basic background on what stock is. In this first section we will give you a brief background on what company stock is, and then explain how stock options are related. This background will set up our later discussion about why companies use options and how they can become valuable.

Stocks (in general)

Shares of stock, which are also referred to as equity, represent an ownership stake in a company. When you have stock in a company, you own a little piece of it. For example, if GENERIC Co. has issued 1 million shares of stock total, and you decided to purchase 50,000 of those shares, you would be a 5% owner of the company. The value of your “piece of the (company) pie” will change over time depending on what price other people are willing to pay for a share of GENERIC Co.; however, your ownership percentage will stay the same. You hope that the company performs well and that the value per share increases.

Many well-known public companies (such as Apple, Facebook, and Walmart) trade their stocks on major, public stock market exchanges1, which makes the stocks very liquid—easy to buy and sell. In comparison, startup companies are normally private, which means their stocks are not traded on public exchanges. This makes stock in private companies illiquid, because there is not a ready market of people waiting to buy and sell the stocks. If you wanted to sell your private company stocks, you would have to personally find another individual who is willing to buy (and to whom you are legally allowed to sell).

Stock options

Stock options are different from shares of stock in that they represent an option (or opportunity) to buy stock at a set price in the future, rather than an actual ownership share of the company at present. As the name implies, stock options give you an option, or choice, but not a requirement, to buy stock. There are other types of stock options that can be bought and sold on the public markets, but in this article, we are focusing on the stock options that companies give to their employees.

For example, if you started working for Startup Co. on January 1, 20X1, and they gave you 100 stock options on that day to buy the company stock in a year at a price of $10 per share (referred to as the strike price or the exercise price), you do not own any shares in the company as of the current date (January 1, 20X1). Rather, the stock options give you the option to purchase up to 100 shares of Startup Co. stock on January 1, 20X2 (a year later) for a price of $10 per share, but only if you want to. That is, on January 1, 20X2, you can buy Startup Co. shares for $10, even if the normal market price is $20, $50, $100, or more. Stock options can become valuable if the price of the stock you receive is more expensive than the price you have to pay. For example, if Startup Co.’s shares have a market price of $20 on January 1, 20X2, and you use your options to purchase 100 shares at $10 per share, then you have spent $1,000 to buy 100 shares that are actually worth $2,000. The $1,000 appreciation in the market value of your option shares relative to your exercise price is often called the intrinsic value of the stock option.

When do you receive stock options?

Stock options are normally given as part of a new employee’s compensation package when she is hired at a company. This is especially common with startups. The mixture of salary and stock options that startups use to compensate their employees varies by company and industry.

Why do companies pay with stock options?

At this point, you may be wondering why a company, especially a startup, would pay with stock options. Why not just grant the stock directly as compensation? Stock options are commonly used by young, startup companies for many reasons, but the most common are for employee (1) attraction, (2) motivation, and (3) retention.

Attraction – In order to succeed, startups need to hire highly qualified personnel, but they often don’t have enough money to pay these desired employees as much as a larger company could. Stock options help startup companies compete with larger firms to hire top talent, without having to pay as much cash up front. Stock options can level the playing field between large companies and startups, because they have the potential to be highly valuable if the startup company grows in the future, but do not cost the startup any cash in the present.

Motivation – Startups also use stock options as a way to motivate employees. Because stock options are only valuable if the company succeeds, stock option compensation should motivate employees to take ownership in helping the company grow (and thereby make their options more valuable). If the company succeeds, everybody wins. The motivation for employees is not the same if the company pays with only a salary, which is fixed regardless of the overall company performance.

Retention – Stock options normally have rules in place so that you cannot use them unless you stay with the company for a set period of time (we will discuss these vesting rules later in this article). Therefore, stock options help startups to retain the talent that they attract, because the value of the option is earned over time, rather than all at once. Employees are rewarded for staying, and the company benefits.

How do stock options work?

Now that we have laid the groundwork to understand what stock options are and why they are so commonly used in startups, we can move onto a deeper explanation of how stock options work.

Stock option dates

Much of the discussion surrounding stock options relates to timing. Therefore, to aid in further discussion, we need to clearly define the four important dates that apply in stock option transactions. These dates are as follows:

  1. Grant date – when the options are given to an employee
  2. Vesting date(s) – when the employee can use the options she was granted
  3. Exercise date – when the employee exercises (uses) her options to purchase company stock
  4. Stock sale date – when the employee sells the stock that she purchased

How stock options become valuable

Because a stock option gives you the right (but not the obligation) to buy a share of company stock at a strike price, options only become valuable if the price of the stock that you can purchase with the option on the exercise date is greater than the strike price that you have to pay. When the price of the company stock is greater than the strike price of the option, we say that the option is in-the-money; if the price of the stock is below the strike price, the option is out-of-the-money; and, if the stock and strike price are the same, the option is at-the-money. If a startup company grows rapidly and is successful, the difference between the strike price and the market price of the stock (called the bargain element2) can be significant.

Vesting

As discussed above, one of the reasons that companies use stock options is to retain talented employees. To accomplish this, stock options normally have restrictions in place so that they cannot be exercised until the employee has stayed with the company for a set period (we call this a vesting period). Therefore, although you may be given options on the grant date, vesting rules bar you from actually using your options on that day. There are two general patterns of vesting: gradual and cliff.

Gradual or graded vesting is when stock options vest (or become exercisable) over time, with a portion of the whole vesting with each contract-specified period of employment (e.g., a month, quarter, or year). It’s very common for options to vest over four years, with 25% of the total vesting each year. In this situation, there are really four successive vesting dates, meaning that the options are not fully vested until four years from the grant date. See Graph 1 for an example of a gradual vesting arrangement over four years with 1,000 options.

Comparatively, cliff vesting is when all options become exercisable at once after a specified vesting date. The vesting date becomes a cliff that, when reached, triggers an immediate jump in the number of vested options. In its most extreme form, a cliff vesting stock option plan would have only one date at which all the options vest, and before which no options have vested. See Graph 2 for an example of a 1,000 option, four-year plan with the cliff at the fourth year of employment.

In practice, many stock option plans are a combination of both gradual and cliff vesting. For example, companies often design their plans so that there is a one-year cliff, at which a specified chunk of the options vest (and before which no options have vested). After this cliff is reached, the options vest gradually, often by month or quarter. See Graph 3 for an example of a plan like this for 1,000 options with quarterly gradual vesting after the first year.

Stock options example

The following is an example of a typical stock option cycle that uses the terminology discussed in this article:

On January 1, 20X1 (the grant date), Brand New Co. (BNC) grants you 1,000 stock options as part of your compensation package, with a strike price of $10 per share. On this grant date, the value of BNC stock is determined to be $10 per share, so the options are at-the-money. The options vest over four years, at a rate of 25% per year (same as the example shown by Graph 1 in the vesting section above). Although a portion of your options vest at the end of each year you work at BNC, you decide to hold onto all options until they have fully vested (4 years later).

On January 1, 20X5 (when the options fully vest), the market price of BNC stock is $110, so the options are ­in-the-money relative to the $10 strike price. You decide to exercise all your options on that day (the exercise date) to purchase 1,000 BNC shares for $10 each (paying $10,000 total). You then turn around immediately and sell those shares at $110 on the same day (stock sale date), making a profit on the $100 per share bargain element. Because of the bargain element, you make $100,000 total ($100/share x 1,000 shares). See the figure below for a graphical depiction of the sequence of events:

In an alternate scenario, if the BNC stock was out-of-the-money at a price of only $9 per share on January 1, 20X5, you would be under no obligation to exercise your options. If you wanted BNC stock, you could simply buy it for $9 in the market (which is cheaper than the strike price on the option) and let the options expire unused.

How stock options are taxed

The government’s taxation of stock options depends on whether they are classified as Incentive Stock Options (ISOs) or Nonqualified Stock Options (NQOs). This article won’t go into the rules behind an ISO or NQO classification. We will only present a high-level discussion of the tax differences between these types.

Generally speaking, stock options are taxed on the value that they provide. Referring back to the BNC example above, this would mean that you would be taxed on the $100,000 bargain element.

For NQOs, the bargain element is treated as ordinary income, which means that you are taxed at ordinary rates on the exercise date (even if you do not actually sell the stock). Any increase in the value of the stock after the exercise date is taxed as a capital gain (a preferential tax treatment at lower tax rates).

Comparatively, for ISOs, on the exercise date the bargain element is not taxed like ordinary income, but rather goes toward the owner’s alternative minimum taxable (AMT) income3. If all ISO rules are met, an employee will not be taxed until she actually sells the stock that she purchased with her options, and the bargain element is treated as a capital gain. This means significant tax savings compared to an NQO. Employees prefer ISOs because of the potential for favorable capital gain tax treatment. However, there are many restrictions on what qualifies as an ISO that often make this type of option less attractive for employers. At startups, employees more often receive NQOs.

For tax and financial reporting purposes, the price at which a private company, whose stock is not traded on a public market, values its stock options is extremely important to the government and the SEC. There are many rules in place so that companies do not artificially adjust the strike price (which should reflect the current value of the stock) to avoid taxes or make it look like the company paid employees less for compensation. For more information on the tax issues of option pricing, see our article 409A Valuations, and for a discussion on how companies run into trouble with option pricing with the SEC, see our article Cheap Stock.

Expiration date

Stock options normally have an expiration date—the date by which you need to use your vested options. For employee stock options at startups, the expiration date is often the earlier of the following:

  1. 10 years after the grant date (this is required for an ISO), or
  2. 90 days after the last date of employment (this is often called the early expiration period)

Therefore, if an employee leaves a company, she must exercise her options quickly or else they will expire unused. These expiration date windows can vary across different stock option plans, and you would need to look at the details of your specific option plan to know for sure what your window is.

How do I use my stock options?

At the beginning of this article, we explained that stocks traded on the stock market are very liquid because they are easy to buy and sell (convert to cash). This is not usually the case with shares of stock in young companies. Even when your options vest, such that you can exercise them, it may be impossible to find anyone to whom you can sell the stock you just bought. This final section of the article will discuss how and when you can use your stock options.

Exercising your stock options

When your stock options have vested, you are allowed to exercise them (purchase company stock) at the pre-determined strike price. As discussed above, on this exercise date there may be tax consequences, depending on whether your option is an ISO or NQO. If your option is an NQO (which it likely is), you will be taxed for the bargain element on the day of exercise.

To exercise your stock options, you need the cash to pay the strike price and (if the stock is an NQO) the associated taxes for the bargain element. This can be a considerable amount of cash in some situations, especially when the stock has appreciated in value significantly and the bargain element is large. Because of this, employees will sometimes seek out loans to get the cash necessary to exercise their options, or they will execute a same-day sale in which they exercise the options and then immediately sell a portion of the stock to cover the cash expenses on the same day (essentially paying the exercise price in stock). However, as you might expect, a same-day sale is only possible if you are able to sell the shares, which means that employees often must wait until a liquidation event before it is financially feasible to exercise their options.

Liquidation Event

Let’s return to the BNC example. You have now worked at BNC for 4 years, so your stock options are fully vested, but the company is still private. BNC has grown significantly and is worth much more than it was when the options were granted to you. However, if you exercise your options to buy BNC shares now, you likely won’t be able to sell them (and realize the financial gains) until a liquidation event occurs.

A liquidation event is when something happens that allows the owners of a company to liquidate (sell) their ownership shares. For startups, a liquidation event is often in the form of an Initial Public Offering (IPO) or an acquisition by another firm. The order of who can sell what stock when a liquidation event occurs depends on the liquidation preferences specified for each option or share, but these issues are beyond the scope of this article. For our purposes, it’s just important to understand that a liquidation event will need to occur in order for you to profit from the options that you exercise. Regardless of how valuable your options might be, you cannot convert them to cash until you can sell the shares of stock underlying the options.

Conclusion

Stock options are very important to many startups and startup employees. They have the potential to create significant personal wealth if a company does well without costing a startup massive amounts of cash, and they help align employee and company goals. This article has provided an overview of stock option basics so that you can better understand the important dates and terminology. If you have questions about more detailed issues, please see our other articles on the topic referenced within the article and below.

 


 
 


Footnotes

  1. Stock market exchanges (often referred to as the “stock market”) are markets in which stocks can be bought and sold. There are stock market exchanges all around the world, but some of the largest and most famous are the New York Stock Exchange, Nasdaq, London Stock Exchange, Tokyo Stock Exchange, and Euronext. Historically, stock markets were places where people would physically congregate to buy and sell stocks, but now, much of the trading is done online. Each stock that trades on a stock market exchange has a ticker, or code, to designate the company. For example, on the New York Stock Exchange, Walmart’s ticker is “WMT.” The price of each stock is readily available online or in business publications.
  2. The bargain element is also commonly referred to as the spread or the intrinsic value.
  3. According to the IRS, the alternative minimum tax (AMT) applies to taxpayers with high economic income by setting a limit on the tax benefits they can receive. It ensures that high income tax payers pay at least a minimum amount of tax. AMT is a very complicated to calculate, and a discussion of it is beyond the scope of this article.
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Author Chapman Ellsworth

Chapman was born and raised in Boise, ID. He is studying accounting and chemistry, and will join L.E.K. Consulting after graduation. Chapman loves pick-up sports, playing the viola, and getting his heart broken by the Arizona Diamondbacks.

More posts by Chapman Ellsworth

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