Everything You Need To Know About Employee Stock Options (With Examples)

By Matthew Zane - Jan. 12, 2021

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Compensation packages can be tricky to understand. One increasingly common benefit, especially among start-up companies, is offering employee stock options. Once reserved for top-level executives, stock options are now being extended to all levels of employees.

You’ve probably heard stories about people getting rich overnight thanks to stock options, and while that certainly does happen, it doesn’t automatically mean that all stock options are created equal. We’ll cover what exactly employee stock options are, how they work, and help you arrive at an educated decision about their value.

What Are Employee Stock Options?

Employee stock options (ESOs) grant employees the ability to purchase company stock for a preset price at a predetermined time. The stocks are not given freely to the employee; they simply have the option to purchase them if they wish to. Think of ESOs as an offer of discounted stocks in the company.

The pre-set stock price is called the “grant price,” “strike price,” or “exercise price.” A company’s shareholders must approve a company’s decision to offer stock options, but, in general, employers have flexibility in choosing the grant price and quantity of stock options offered to employees.

Employee stock options have expiration dates, and if you leave the company before purchasing the stock, that expiration date may be foreshortened.

Overall, stock options can make up a significant proportion of your compensation plan. They are a commonly-offered benefit among start-up companies that don’t have the capital to offer competitive pay for top-talent. Instead, they provide the chance for a big payday later on in place of a bigger paycheck in the here and now.

How Employee Stock Options Work

There are a few steps and terms you need to know to fully understand how employee stock options work. Let’s break those down before we look at an example:

  1. Sign an employment contract with ESOs. Your employer will offer you a set amount of stock options to purchase up to a certain amount of shares in the company for a preset price. You agree to these conditions when you sign your employment contract.

  2. Wait for the “cliff”. ESOs typically have a “cliff,” which means the waiting period before you can exercise your options. Usually, companies will instate a one-year cliff, meaning you have to wait one year before you can take advantage of your options.

    If you leave your employer before this period, you lose your stock options, incentivizing you to hang around.

  3. Understand the vesting period. In addition to a cliff, ESOs also have a vesting period (similar to 401(k)s). A typical arrangement is to have a four-year vesting period, meaning after four years, the employee has the option to purchase the number of stocks laid out in their employment contract.

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    Options vest over time, so in the case of a four-year vesting period, you would have the option to exercise 25% of your options after completing your first year, 50% after your second year, etc.

    Depending on your contract, options then continue to vest, either monthly or annually. So in the case above, each month, you would have access to exercising an additional ~2% of your options each month, or 25% each year.

  4. Exercise your options. Once a certain proportion of your options have vested, you can exercise them. Exercising your options just means that you’re actually buying stock in the company.

    Regardless of the company’s performance, the grant price (predetermined in your employment contract) remains the same. Your stock options have no inherent value until you exercise them.

    You have a few options when exercising your options:

    • Buy the stock. The one most people think of is simply purchasing the stock and holding onto it. When you buy company stocks, you still need to pay any commissions, taxes, or fees associated with the broker you use.

    • Sell the stock. You still have to buy the stock first, but nothing prevents you from immediately flipping it by selling it for the market price.

      Brokerages may front you the money for the initial purchase, so you don’t need to have a lot of cash on hand to exercise your option in this way. You walk away with the profits after paying any brokerage fees.

    • Sell some and keep some. If you want to hedge your bets and effectively pay nothing, you can opt to sell enough stock to cover the purchase price and any associated fees while retaining a portion of your stocks.

      It can be a win-win because you don’t have to put any money down, but you’re still invested in the company.

Note that stock options are only valuable if the grant price is lower than the market price of the stock.

In cases where the grant price is higher than the market price, your option is “underwater.” You have no reason to exercise your options because you’d be better off buying the stock on the market, like anyone else.

Employee Stock Options Examples

That’s all great from a theoretical standpoint, but it’s illustrative to examine a real example to get a better idea of how to make the most of your ESOs. Let’s take a look at Sara, a new employee at a start-up whose employment contract includes ESOs:

  1. Sara signs an employment contract. The contract offers the option to purchase up to 10,000 shares in the company at a price of $1 per share. Her contract stipulates a one-year cliff and a four-year vesting period.

  2. Sara works for the company for one year. One year has elapsed, and Sara now has the option to purchase 25% of the stocks agreed upon in her contract (2,500 shares). The current market price of the stock is $2, so Sara can choose one of four options here:

    • Buy between 1 and 2,500 shares at $1 each and hold onto them

    • Sell between 1 and 2,500 shares and earn between $1 and $2,500 (before brokerage fees)

    • Sell 1,250 shares (for $1,250 profit) and use the profits to buy an additional 1,250 shares (earning her these shares for free, essentially)

      She can also sell/hold any amount of shares she sees fit; she doesn’t have to break even perfectly

    • Wait and do nothing

  3. Sara works for the company for four years. At this point, all of Sara’s stock options are vested, meaning she can exercise her options on up to all 10,000 shares total.

    Unfortunately, at this point, the company’s stock price on the market is only $0.75. In this case, she has no reason to exercise her options because she would lose money if she did.

  4. Sara waits for the expiration period. Contracts will determine an expiration date for stock options, typically ten years after the grant date.

    Seeing as her options are currently underwater, her best course of action is just to wait and see how the company’s stock does over the next six years (presuming she stays with the company that long).

    Two years later (six years total in Sara’s employment period with the company), the market price of the company’s stock is up to $3. At this point, Sara can make a substantial amount of money ($20,000) by exercising her options and selling her 10,000 shares.

    Or, if she believes the company will continue to thrive, she can simply purchase 10,000 shares for $10,000 and hold onto them. Finally, she can decide to sell 3,000 shares (or however many she wants) at $3 each ($6,000 profit) and purchase 7,000 shares at $1 each, essentially getting her 7,000 shares while only paying $1,000 out-of-pocket.

That’s what happens if you stay with your company for an extended period. Let’s take a look at this scenario again, but supposing that Sara quits or is terminated at various times:

  • Sara leaves the company before the cliff period concludes. Sara signed a contract with a one-year cliff, but she decides to quit or is terminated six months into her employment. Her stock options vanish, and she receives no compensation.

  • Sara leaves the company after the cliff period but before options are fully vested. Let’s say Sara works at the company for two years before resigning or getting the ax. Up until now, she hasn’t exercised any of her options. A typical arrangement allows Sara three months after concluding her employment to exercise her options.

    She can exercise as many options as she has vested. So, with a four-year vesting period, 50% of Sara’s options would be vested by the two-year point. She can choose to exercise up to half of her options (5,000) or none of them if the option is underwater.

    She can also use that three-month period to see how the stock performs on the market but would only opt for this if the option was near getting underwater.

    From the example above, with a grant price of $1 and a market price of $0.95, Sara would have no reason to exercise her options immediately. But, if, after two and a half months, the market price is $1.05, Sara can make a small profit by selling her stocks (5,000 stocks x $0.05 profit per stock = $250).

  • Sara leaves the company after her options are fully vested. This is pretty much the same as the above scenario, except that Sara can now exercise all of the stock options originally laid out in her employment contract.

Employee Stock Options and Taxes

The money you make from stock options is not typically tax-free. First, let’s talk about two categories of stock options:

  • Non-qualified stock options (NQSOs). These are the most common type of stock options and the ones we’ve been discussing. The federal government does not give special tax treatment to NQSOs.

  • Incentive stock option (ISOs). These are typically given to high-level executives and receive special tax treatment from the federal government.

For the stock options we’re talking about (NQSOs), the federal government treats any profits as regular income. Your company will report your income from exercising options on your W-2.

So if you chose to exercise your option by selling it to earn a quick $2,500, that money would be taxed. It’s technically a “short-term capital gain,” but it amounts to regular income tax.

However, if you hold onto your shares for a year or more, your tax burden is lower. That’s because you’re paying taxes on “long-term capital gains.”

Final Thoughts

Stock options are a nifty yet risky perk that employers can use to incentivize employees. After all, you’re a (potential) shareholder who has a direct impact on the company’s value.

It’s crucial to take expected compensation through stock options with a grain of salt. Start-ups use them to make up for their less-than-stellar salary offerings, so you’re taking an immediate pay cut with the hope of a big payday down the road.

But in the meantime, that stock could crumble, either due to failures within the company or a widespread economic downturn. You might also not stick around long enough to exercise your options or arrive at a point when exercising them would actually net you a profit.

Stock options could be your golden ticket or a worthless part of your compensation package, so be sure to vet the company in question and come to your own conclusions. There’s no right or wrong answer to accepting a job with stock options.

Still, we advise against working for a company you’re not excited about if you’re only in it for the potential payoff years down the line.

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Matthew Zane

Author

Matthew Zane

Matthew Zane is a teacher, writer, and world-traveler. He writes articles to help people at every stage of the career life cycle. He completed his masters in American Literature from Trinity College Dublin.

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