Your Guide to Understanding Stock Options

What are stock options?

Stock options are a type of equity compensation that gives employees the ability to buy or exercise a certain number of shares of company stock at a preset price within a certain period of time.

There is no set number of stock options that every company grants; it varies by company. Your employer likely also offers varying numbers of stock options to different employees, often based on their position or seniority.

Why do companies issue stock options?

Companies issue stock option plans as a benefit. They often leverage option contracts as a way to lure and retain talent in a competitive job market. Some startups offer stock options as part of your compensation package. These companies may leverage stock to boost overall compensation in the event that they cannot compete on salary with other employers.

What types of stock options are available?

There are two main types of stock options available: non-qualified stock options (NQSOs) and incentive stock options (ISOs). Employees and independent contractors are eligible for NQSOs, while executives who are employees can receive both NQSOs and ISOs (a non-employee member of the board of directors can’t receive ISOs). ISOs don’t have an employment tax upon exercise while NQSOs do.

Some companies also grant restricted stock, restricted stock units (RSUs) or stock appreciation rights (SARs) in place of stock options. Restricted stock and RSUs give you the right to receive shares, by gift or purchase, when you work a certain number of years or hit a performance target. SARs let you receive the increase in the value of a certain number of shares, which can be paid to you as cash or more shares.

How does the stock option process work?

Investors in a company and other stakeholders help decide who can receive stock options, as well as when the period to grant stock options opens.

For example, as an employee, let’s say you receive stock options that give you 20,000 shares.

To accept these shares, you’ll need to sign a contract that explains the terms of exercising your stock options. The contract will list a grant date, which is the day your options begin to vest. Vesting means your stock options are available to buy.

Rather than getting all 20,000 shares at once, they vest over time. Your contract will define the vesting period. For example, let’s say your 20,000 options have a four-year vesting schedule. That may mean that 5,000 of those stock options vest each of those four years. After two years of employment, you’ll have the ability to exercise 10,000 of those stock options.

When can stock options be exercised?

Your company will tell you the amount of time you have to exercise your stock options before they expire. Before exercising your stock options, those shares don’t hold any market value. The price listed in the contract for those stock options is the stock price, strike price or exercise price. The price isn’t tied to company performance, so it remains the same regardless of the stock’s market price.

If you are working with the stock option scenario mentioned above and each share is worth $1, then you need to pay $20,000 to buy those options. When you exercise these stock options for $20,000, you will then own that stock and can choose to hold or sell it. There will still be commissions and fees as well as ordinary income taxes (capital gains taxes) when you decide to sell these options.

Are there other choices for exercising stock options without cash?

One possibility is to do an exercise-and-sell transaction. This transaction involves purchasing your options and immediately selling them. Instead of delivering the $20,000, a brokerage fronts you the money and uses proceeds from the sale to cover the costs of buying and selling the shares. Then you receive any proceeds from the transaction.

Another possibility is the exercise-and-sell-to-cover transaction. With this option, you only have to sell the number of shares that will cover the purchase of those shares. Then you can hold on to the rest of the shares.

What should you know about stock options if you plan on leaving the company?

It’s important to know the available holding period for exercising your stock options. Typically, the expiration date is 10 years, but it’s best to check the contract you signed. There may be a new limited time period, typically 90 days, after you leave the company during which you must make a decision and exercise your ISOs or your company may convert them to NQSOs. Otherwise, you can lose this right.

For example, most contracts come with a “cliff.” With the stock option scenario mentioned above, let’s say your four-year vesting period also comes with a one-year cliff. That means you have to remain with the company for at least one year after the start date to receive the first batch of your stock options. If you leave during the first year of employment, you don’t receive any of the stock options.

Plan ahead when considering stock options

Now that you know more about stock options, you can make informed decisions when and if your company offers them as part of your compensation package. Make sure you talk to a financial advisor regularly about this type of equity benefit and all the processes involved .