What the heck is an employee stock option?
Publicly traded companies may offer employees stock options as a form of incentive compensation. These options give you the right to purchase company stock at a specific price. There’s a lot of jargon to share when it comes to employee stock options.
The initial price, when you first receive an employee stock option, is called the grant, exercise, or strike price.
The employee stock options also have a vesting date and an expiration date.
The vesting date is when you can start exercising the options. To exercise an option, means to choose to purchase the stock at that specific price.
The expiration date is (duh) the date when the options expire, and you can no longer exercise them.
Why do companies do this?
Well, for one thing, if the company is a start-up, they may not have a lot of cash flow to offer employees high salaries. But they could issue employees shares of stock, and then, ideally, in the future, the company will take off and those shares could be worth a lot of money. Companies also use stock options as motivation. If an employee is issued shares of stock, they have an incentive to work hard to make the company profitable, which will increase (theoretically) the share price of the stock. Research shows (probably, I’m not quoting any stats here) that if the person has an ownership stake in something, then they will value it more/take it more seriously/work harder to make that stake grow.
How does it work?
Stock options work best when the market price of the stock is above the exercise/grant price. For example:
- I issue you stock options (shares) of Jill, Inc. with an exercise price of $10.
- The current market price of 1 Jill, Inc. share is $15.
- If you exercise (buy) the shares at $10, you can immediately sell them for $15 in the market, therefore making a profit of $5/share. Bam!
- The difference between the exercise price and market price is also called the spread.
There are 2 types of employee stock options, and they have different tax consequences.
- ISOs (Incentive Stock Options) which are usually only offered to executives/key people.
- NSOs (Non-qualified Stock Options or Non-Statutory Stock Options) which tend to more prevalent because they can be granted to employees at all levels, including consultants and board members.
When an employer grants you options, that is not considered a taxable event. It’s only when you DO something with them that you must pay attention and figure out if it is taxable or not. It can get complicated, so engaging an accountant may be a good idea.
As always, if you have questions, feel free to email me.
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