A Primer on Company Stock Options
Over the years we have witnessed more than a few clients build a substantial amount of wealth via their employer stock options. Admittedly, we have also seen instances where a client had and subsequently lost a great deal of money because they either mishandled their stocks options, or circumstance beyond their control moved against them. As a result of these experiences, we see a strong need to help educate our clients on the entire landscape of stock options and how to get the maximum value on them. So let’s dive in:
What Are Company Stock Options?
You probably have heard about stock options in your company or your industry, but what do they mean? If you’ve ever been offered stock options as a form of compensation, it can seem like an attractive proposition. However, before accepting the offer, you need to know what they are and how they operate.
Stock options refer to the rights given to employees and executives of a company, which allow them to purchase shares in that company’s stock. The premise is that if the business takes off, they will have made a wise investment, while if it struggles or goes under, they lose nothing more than their time spent checking on its progress.
It can be tempting for an employee who has been offered this form of compensation to immediately take whatever options are available without considering all the implications. That would not do justice to either party. A savvy individual should inquire about specific details before signing any agreements to not get burned by unexpected consequences down the road.
When a stock option is awarded, the right to purchase stock within the company is not granted immediately. Instead, it accrues over some time when the company meets its performance goals. This encourages the employees to stick with the company until it meets its goals.
Types of Company Stock Options
Companies offer two types of stock options to their employees:
- Incentive stock options (ISOs)
- Non-qualified stock options (NQSOs)
Incentive Stock Options (ISOs)
An incentive stock option refers to a corporate benefit that allows an employee to buy shares of the company at a discounted price, but only once. This type of option is called “incentive” because it’s meant to entice workers with financial incentives for them to stay employed long enough for a company’s stock price to rise significantly.
ISOs are offered to key employees and top management employees of a company, and they’re classified as an employee benefit. When the company’s stock price increases above what’s known as an exercise price or strike price, employees can buy shares at that discounted rate for their personal use.
ISOS can be paid upfront with cash, stock swap, or through a cashless transaction. One huge advantage with ISOs is they can be exercised at a lower market price, providing immediate profit to the employee.
Since ISOs are employer-provided incentives to keep these key workers on board with long-term commitments, only certain types of companies have them available–namely those who aren’t publicly traded corporations but instead privately held businesses.
ISO Critical Dates
Incentive stock options have critical dates that you need to keep in check to reap maximum benefits. These dates include:
A grant date refers to the time stock shares are allocated. During the grant date, shares are valued and determined by the exercise price. However, the date for exercising the option to buy shares is not always tied directly to the grant’s date.
The vesting date is when the incentive stock options become available to employees. The number of vested shares depends on the terms in your agreement with your company because some plans have set dates and others let you take a certain amount over time.
This is the last day for employees to exercise their right to purchase shares at the exercise prices. Failure to exercise your rights by the predetermined deadline, you lose your shares for good along with the chance of making money on that stock purchase.
ISO Tax Considerations
One advantage ISOs have over other employee stock purchase plans is their eligibility to receive favorable tax treatment.
The tax rules for exercising options are markedly different from non-statutory ones. When an employee exercises a non-statutory option, they will have to report the bargain element of the transaction as earned income that is subject to withholding taxes. As an ISO holder, you do not need to worry about anything until your stock is sold — no reporting required at this point!
If you’re a qualified employee, then your sold vested shares will only be taxed as short- or long-term capital gain. But if it’s not a qualifying transaction, you must report any bargain element from their exercise and pay ordinary income tax on it instead.
Non-Qualified Stock Options (NQSOs)
An NQSO is an employee stock option offered by an employer, where, as an option holder, you pay ordinary income tax on profit made after exercising your shares.
They are a strategy companies use to reward employees for performance and incentivize employees to stay with the company.
Non-qualified stock options are a legal agreement between an employer and employee, which outlines the terms at which the company is willing to sell you stock. These NQSOs grant with the expectation that the value of said stocks will increase, so employees may reap their benefits in its rise.
Unlike ISOs, these options are offered to workers not considered employees, such as consultants and contracts.
The price of NQSOs is equal to the market value before the grant date. Through an expiration date, employees can exercise their options before the deadline, where they would lose their options.
Employers use NQSOs, just like other stock options, to reduce the cash compensations they pay their employees. However, you should stay at the company till the options are vested, lest you risk losing them.
Employer-Sponsored Options are a form of equity compensation vested when the employee exercises their option to purchase company stock. However, they may not be fully vested as companies can limit this occurrence by limiting an employee’s access to avoid them making quick profits and subsequently leaving.
Options grants are an excellent way to receive equity in the company, as well as financial security. However, they aren’t without their drawbacks. You have to be a careful and diligent reader of your options plan — which is drafted by the board of directors and contains details on what rights employees can enjoy with these plans and your individual options agreement that will provide critical information.
This information includes how ESOs vest over time (and if there are any restrictions), shares represented by this grant, or even just when it’ll expire after some time has passed since being granted. Your investment into future stock could lead to either immense success or result in nothing at all should things go south.
Taxation of NQSOs
Unlike ISOs, holders of NQSOs are subjected to taxation based on the stock price when exercising the options as it creates a reportable income.
The way an NQSO can be taxed is at the time of grant and upon exercise. Usually, when someone receives a stock option from their employer, they are granted it with no obligation to use or pay for it until some trigger event like retirement or leaving employment (i.e., exercising).
Becoming Over-Weighted in Your Company Stock as a Result of Vesting ESOs
If you are leaving your employer because of the position or company, it is crucial to know how many stock options you have in that company. You might be overweighted in the company’s stock due to the vesting of stock options and so need to pay attention before making any decisions about what stocks to sell off at this time.
An excellent way to ensure you aren’t over-weighted is to look at the “Estimated Value” column on your restricted stock unit (RSU) or award summary. This is calculated by multiplying three factors together:
- The number of shares you own,
- Your vested percentage in those shares, and
- A company’s current share price
Then divide that value by the total vesting period to determine your average monthly return if you liquidated all of these stocks today. And then compare this with how much money it costs to buy an equivalent amount of stocks from someone else every month for a year as an estimate of future returns. If this latter figure exceeds the former, then you are overweighted. It may also mean that you are holding too many stocks because your company’s stock price is declining.
Stock options are an excellent way to diversify your portfolio, but you must work closely with a financial advisor before making any decisions. To make informed stock option purchases, there must be an understanding of the various risks involved and how they will affect other aspects of your investment strategy as well. The team at Infinium stands ready to assist you in optimizing your company stock options for maximum benefit. Contact us today to schedule a one-on-one meeting with our financial advisors.
Mark is a +24 year financial advisor veteran and Certified Financial Planner™. He founded Infinium in 2009 to bring a more personal, and truly client-centric offering to investors.