January 30, 2020
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Employee stock options (ESOs) are one of the ways in which companies offer their employees a path to ownership in the company. (Other ways include stock grants, Employee Stock Ownership Plans (ESOPs), Stock Appreciation Rights (SARs), and 'phantom' stock). ESOs, however, are the more common approach in the tech world and among startups. If your employer offers and of these as part of your compensation or benefits, consider yourself fortunate...but also understand how they work so you can take maximum advantage and not receive any unwelcomed surprises like forfeiting your options or receiving a huge unexpected tax bill.
Like their cousins in the investment world, employee stock options are legal contracts – in this case between the employer and the employee. In concept, they are similar in form and function to listed stock options, but there are significant differences in terms, marketability, and taxation. (A quick comparison table is included below.)
First, ESOs are not standardized and are not tradeable on an exchange. Even if you get employee options from a company like Starbucks that also has conventional listed options trading on its stock, your employee options would be separate and non-interchangeable with the listed options. ESOs represent a customized benefit for each employee who receives them and the terms can be different for each employee.
ESOs are ‘purchase’ options, making them equivalent to call options in the trading world. Receiving an employee option means you have been granted the right to purchase stock in your employer’s company for a given time period at a fixed price. That right is backed by a legal contract from your employer, who is obligated to sell you the stock if, and when, you exercise your right.
One major difference between an employee stock option and a conventional call option is that conventional options are standardized and there is an active market for them. The great majority of conventional options (well over 90%) are not exercised – they are simply ‘closed out’ by investors before expiration to realize a gain or loss on the trade. Since they are standardized, closing one simply means selling it back into the market. Closing in this manner is not possible with ESOs. This means that employees don’t have the luxury of trading their options when they want to take a profit or a loss. Employees have no choice but to exercise their options to realize value from them, and exercise requires purchasing the underlying shares.
Employee stock options may be one of two types:
1. Non-qualified stock options (NSOs)
2. Incentive Stock Options (ISOs)
NSOs are broad-based employee benefits that are typically available to all eligible employees (with eligibility dependent upon things like a minimum term of employment at the firm or full-time employment). The reason they are called ‘non-qualified’ is that they do not qualify under ERISA laws as retirement plans and do not enjoy the same tax treatments. ISOs are more typically given to managers or executives as an incentive bonus.
Needless to say, all ESO contracts have terms that are spelled out in detail and are generally non-negotiable. It is critical to familiarize yourself with the terms of your option contract (including the fine print!), as they all differ and they can include details that could have a big influence on how you proceed with your options.
Key Terms include the following:
The Underlying Security
Normally, this would be the common stock of the employer company. That stock may or may not necessarily be publicly traded. If it is publicly traded stock, that’s a plus in that it means once you own that stock, you can plop it into your brokerage account and trade it as you wish (taxes and commissions notwithstanding). But if your employer is a private company, then your stock might not be easy to value, much less sell. That doesn’t mean non-public stock is a bad investment – just that it will be far less liquid and less convenient to deal with.
You should make sure you understand exactly what you would be buying if you exercise your option as it could also be some special type of stock like a different share class. The option contract will also specify how many shares of the underlying security you may purchase. This will normally serve as a maximum, allowing you to exercise for fewer shares if you like. (Also, it is not uncommon to receive multiple option grants during your employment with each one having different prices, dates and amounts of shares.)
An expiration date
All options are dated and have a temporary life. Naturally, this too is quite important since options truly do expire on a set date, making them a “use it or lose it” affair. Your option may or not have any value at expiration, but if it does, you will need to take action or it will literally disappear after its expiration. (Listed options expire also, but there is a safety protection for option investors that will automatically exercise the option if it has positive value on expiration date. Not so for employee options.)
An exercise or grant price
The company will be specifying a price in the contract at which you can purchase the stock (considered the strike or grant price). It is a single price good for all the shares in your contact and for the contact’s duration.
Employers will commonly impose a minimum vesting period or vesting schedule on employee stock options. The vesting period is a term of employment that you must exceed before you can exercise your options. If the vesting period is say one year from your grant date, then you cannot do anything with your options until that period is up. A vesting schedule might say you are granted options on a total of 3000 shares but that you cannot exercise more than 1000 in any calendar year. Vesting is done to require a minimum employment commitment on your part before your options can be used. If you leave the company before your options are vested, you would forfeit them.
There may also be a minimum holding period on the stock as well, once you exercise. It will certainly be helpful to know that you might not be able to sell your stock immediately after exercise if that is your intention.
Options theoretically have two components of value: an intrinsic value component that is derived from the value of the underlying stock; and a time value component that is a function of how much time remains until the option expires. We noted above how the value of your stock options will fluctuate with the value of the underlying security. This should be rather intuitive – the higher the value of the underlying stock, the greater the value in being able to buy it at a lower price. It is a very straightforward relationship, with intrinsic value being determined simply by subtracting the option’s exercise price (the price you would buy shares) from the current market price of the shares (the assumed price you can sell the shares.)
The time value component of an option is essentially a value that comes from having the right to purchase stock for some period of time. It translates into the probability that the underlying stock will go up during that period and make even more money for the option holder. In listed options, the time value of an option is readily apparent and measurable, but in an employee stock option it essentially reduces to zero, since the option cannot be sold to anyone else to realize that value.
You have an employee stock option for 1000 shares of Yeehah, Inc. at $10/share. The stock is publicly traded and is currently selling at $25/share.
The value of your options = (Market price – Exercise price) x number of share
= ($25 – $10) x (1000)
Figured this way, the value of your options equates to its intrinsic value, which is essentially what the options would yield in gross profit if you exercised them and immediately sold the stock at the current market price. If you can buy stock at $10/share and it is selling (or valued privately) at $25/share, then woo-hoo, you have a gross profit of $15 per share. On the other hand, if the stock is $5, then boo-hoo, your option is worthless. (Options cannot have negative value – they would simply be considered to be worth zero.)
Don’t be fooled into letting yourself think you should buy shares when the value of the shares is less than your grant price. That would generally not be in your best interests, even if you think the stock will eventually be $100. If you feel that way, then buy it at $5 rather than exercising an option to buy it at $10. (One exception to this might be a situation where you have options on a non-public stock and exercising your options might be the only way you could buy any of those shares at all. You might consider paying a modest premium just to be able to get them at all.)
For practical purposes, one needs to keep in mind a number of factors that will affect what you would actually receive if you exercised your options and sold the stock:
1. Your profit (the intrinsic value) will be reduced by any transaction costs involved. There usually aren’t any on your purchase, but there could be costs when you sell the stock in the market.
2. Risk! The stock price can be expected to continually change in value and you may receive more or less value when you ultimately sell it. Therefore, if you exercise the options and then hold on to the stock, your profit may grow or decline over time.
3. One way or another, the IRS will take a bit out of your options-related gains for taxes. Exercising NSOs can constitute a taxable event and selling the shares later from any option exercise will constitute a taxable event. A tax on the exercised value might be especially painful since you would be taxed on something you may not have even sold yet. (More detail on taxation below.)
4. If you have to borrow money to purchase the shares, you may also have an interest cost to consider.
5. If the stock is not traded publicly, you may not know its true value or be able to sell it easily.
Taxation on employee stock options can be a bit complex and the rules are different from the way regular listed options are taxed. Taxes are thus one of the biggest concerns associated with employee stock options. You should check your individual situation with a tax advisor, but here are the basics:
For non-qualified options:
● Receiving an NSO grant is not a taxable event.
● The first taxable event is when you exercise an NSO. You are taxed on the value to you of this exercise, called a bargain element, just as if was a year-end bonus.
The taxable amount of the benefit is the inherent gain on the stock between your exercise price and the current price and the tax rate is your ordinary income tax rate. There is no getting around this and it can represent a sizeable tax liability, especially since it is at ordinary income rates. It might also trigger an Alternative Minimum tax liability for that tax year as well.
● A second taxable event occurs when you sell any of the shares. This will be a capital gain or loss and taxed accordingly, using your exercise price as the cost basis. (An additional restriction is that you cannot qualify for a long-term capital gain tax rate unless you hold the shares for at least one year and at least two years have passed since your original grant.)
For Incentive options:
● Receiving an ISO is not a taxable event.
● Exercising an ISO is not a taxable event (but could still trigger an AMT liability).
● You will be taxed on the eventual gain or loss on the stock when you sell it as a capital gain, with the same restriction as above.
Beside the psychological pain of having calculated your profit in your options only to give some of it back in taxes (blame behavioral economics), the biggest problem is that you need to pay tax on the value of an exercise before you realize your gain from it. This makes tax planning a necessity. If you are going to exercise options that will create a substantial tax liability, you may want to consider something like having additional tax withheld from your paycheck in that year to lessen the blow when you pay your taxes and remove the possibility of paying a penalty for under withholding.
Stock option strategies:
With regular listed options, there are an extensive number of strategies one can employ, but with employee stock options, your strategy is generally going to revolve around timing, taxes, and tying up capital.
Your options lock in a price for you, so there is no price advantage for exercising early vs. later. In general, people tend to exercise later as they won’t need to borrow or tie up any capital until they do. However, you may want to be able to hold the stock for at least a year to get the more favorable tax treatment from long term capital gains and you might want to sell the stock down the road for something like putting a down payment on a house. In that case, you might adjust your purchase timing to be sooner rather than later so that you can get your one-year holding period on the stock over with and then sell the stock to buy your house.
Naturally, your view of the stock’s future prospects should play a role in your strategy. If you feel the stock has a lot of long-term potential, you might want to hold on to some or all of it indefinitely. On the other hand, if you feel the stock is too volatile in price for you, or you don’t want so much of it in your portfolio, you might sell some or all of it soon after purchasing, despite the higher tax rate. This is the kind of decision to discuss with one of GoodWealth’s sherpas who can help you assess the risks, opportunities, and tax consequences of your stock option strategy.
Summary of important things to consider:
● The terms of your option contract
● The vesting schedule
● Tax consequences and liabilities
● The cost of holding the underlying stock
● The risk of holding the underlying stock
● Comparison of Conventional listed options with employee stock options
Comparison of Conventional listed options with employee stock options
1. The National Center for Employee Ownership
2. The NCEO stock options handbook
3. Forbes article