Chris Chai
Introduction
Employee equity stock options are a popular form of non-cash compensation, especially at startups and technology companies. Options provide employees the opportunity to own shares of the company that they work for, aligning their interests with those of the business. However, the details can be confusing for many employees who are new to the world of equity compensation. In this post, we will break down the basics of employee equity stock options, how they work, and what employees need to consider.
What Are Employee Equity Stock Options?
Employee equity stock options are a form of non-cash compensation that companies offer to their employees. These options provide the right (but not the obligation) to purchase company stock at a predetermined price (known as the exercise price or strike price), typically following a certain amount of time (vesting period). Companies offer options in order to attract and retain talent, since the options have potential to materially increase in value if the company’s stock does well.
Types of Employee Stock Options
- Incentive Stock Options (ISOs)
- Typically offered in the earlier stages of a company’s life to key employees and executives.
- ISOs may offer preferential tax treatment, if certain conditions are met. When planned for and executed correctly, shares obtained from ISOs are often taxed as capital gains rather ordinary income (which is taxed at a higher rate).
- ISOs are subject to a $100,000 limit, which prevents employees from receiving more than $100,000 of exercisable ISOs per calendar year.
- They come with certain restrictions and holding requirements.
- Non-Qualified Stock Options (NSOs)
- Typically offered to employees, directors, contractors, and others.
- NSOs do not qualify for special tax treatments (like ISOs).
- They are taxed as ordinary income at the time of exercise.
How Do Stock Options Work?
- Granting of Options
When you receive stock options, you are granted the right to purchase a certain number of shares at a fixed price (the exercise price or strike price).
- Vesting Period
Options usually come with a vesting schedule, which specifies how long you must remain with the company before you can exercise them (although early exercise of unvested options is sometimes possible). A common vesting schedule is a 4-year vesting period with a 1-year cliff, which means that 25% of the options vest after the first year and the remaining options vest monthly or quarterly over the following three years.
- Exercising Options
Exercising options means that you purchase the shares at the exercise price. In other words, you spend cash to buy shares. The difference between the exercise price and the current market price of the stock is known as the spread or bargaining element (and this amount is important for tax purposes).
- Selling the Shares
After exercising options, you may choose to keep or sell the shares. If you decide to sell and the market price is higher than the exercise price, there will be a gain. However, if the company’s stock price declines, then the stock will have a loss.
Tax Implications
Understanding the tax implications of stock options is crucial. The tax treatment varies depending on the type of options (ISOs or NSOs), when you exercise them, and how long you hold the shares.
- ISOs
If you hold ISOs for more than two years from the grant date and one year from the exercise date, then the gain is typically taxed as a long-term capital gain (which usually has a lower tax rate than ordinary income). However, exercising ISOs may trigger the Alternative Minimum Tax (AMT). AMT is a parallel tax calculation that differs from the regular income tax calculation. Before exercising ISOs, we often recommend that clients work with a financial advisor and/or tax accountant to determine their AMT tax liability and avoid the “AMT trap”.
- NSOs
The spread between the exercise price and the fair market value at the time of exercise is taxed as ordinary income. Any subsequent gain or loss from holding the shares is taxed as capital gain or loss.
Key Considerations for Employees
- Understand Your Vesting Schedule
Knowing when your options vest is essential, as it typically determines when you can exercise them. Exercising your options sooner often saves meaningful amounts of tax, especially if the valuation of the company increases significantly in the future.
- Assess the Financial Risk
Exercising options requires purchasing shares, which involves financial risk. Consider your personal financial situation before exercising options, especially if you plan to hold onto the shares for potential future gains. Talk to your financial/tax advisor before exercising your options in order to better understand the potential risks and benefits.
- Stay Informed About Your Company’s Performance
Keep an eye on company developments, market conditions, and industry trends that could impact a company’s valuation.
- Plan for Taxes
Consult with a financial/tax advisor to understand the potential tax consequences of exercising and selling your options.
- Diversification
Avoid putting all your financial eggs in one basket. While stock options can be lucrative, they are also risky. Consider diversifying your investments to manage risk or take some money off the table.
Conclusion
Employee equity stock options can be a powerful tool for wealth building. However, they come with complexities that require careful consideration and planning. By understanding how stock options work, the types available, and the associated risks and tax implications, employees can make informed decisions as they attempt to maximize the benefits of their equity compensation. If you have questions about your stock options, please feel free to reach out to us for a complimentary call to discuss.