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Stock Options 101 Thumbnail

Stock Options 101


Many of my clients have equity compensation they have earned through the years. There are a few truths about equity compensation. First, it is a tremendous way to grow your wealth directly through your company’s success. Next, it can rather complex and quickly.  I help clients understand and make sense of their equity compensation so they can do the things they want in retirement. 

In this article I am going to talk about Stock Options. As a reminder, a stock option is a way for you to directly participate and hopefully benefit from your employer’s success. You know, assuming the price of the stock goes up. And this fact is important because there is no financial risk to you until you exercise the options. As another bonus, there are no taxes with stock options until you exercise them. This is different than if your company provides you a cash bonus. 

A stock option is an agreement that provides terms under which you can buy a specific number of shares at a set price. The details are included in your employer’s stock plan document, so be sure to get a copy of it so you know the rules unique to your employer. 

When you are granted stock options you have the right to purchase a set number of shares at a specific price during a fixed timeframe. The specific price is referred to as the Exercise Price and when you decide to purchase the shares you have Exercised your options. 

There are a couple of common time periods involved. The first is the vesting period which comes in one of two forms. Vesting is when you can actually exercise your stock options and buy them.  One form of vesting is Cliff Vesting. This is when you reach the end of the set time period and you can now buy all of your stock options. For example, let’s say you have an option to buy 4,000 shares and your vesting period is 4 years. Until the end of that four-year period you cannot exercise any options. However, at the end you can exercise all 4,000 of them.  The second type of vesting is graded vesting. This is more gradual. In this case, you may have 25% of your options vest every year. So, every year you could exercise 1,000 shares based on the previous example. These are the two examples of your company’s vesting schedule with which you should get familiar.

Now, the second time period you want to be aware of is actually more important. It is the overall time period for when you can exercise your options. Most employers set this at 10 years. If you do not exercise your options within this 10-year time period you lose those options.  The last data I saw said 11% of in-the-money stock options expired because people did not pay attention to the overall time period. Do NOT be part of that statistic!

Let’s walk through a quick example here. Again, you have 4,000 shares of stock options awarded to you and your employer has graded vesting of 25% a year.  These shares have been awarded when the stock price is $20.

•    1,000 shares vest every year. After 4 years all 4,000 shares are fully vested.

•    After this time, the stock price has increased to $35 a share. 

•    You now have the ability to exercise these options and buy the 4,000 shares at $20, even though they are worth $35 a share. So, you pay $80,000 for shares that are worth $140,000 on the open market. Not too bad!

Before I forget, and this is important, while most stock options vest based on a time period, there are those that vest based on achieving other requirements, such as sales goals. Again, be sure to know the details for your stock options. Also, if you leave your job before you are vested you typically lose those options. For vested shares you usually have a very small window of a month or two in which you can exercise those options.

Back to when you exercise your options and how you pay for them. Most employers allow you different ways to pay that $80,000 bill.

•    If you have the cash, they may permit you to just pay the $80,000 bill.

•    Others may permit a salary deduction. This is going to be more common if your bill is $800 vs $80,000.

•    Finally, and this is what I see most often is a cashless exercise. Here there are shares sold immediately when you exercise your options and the proceeds will pay that $80,000 bill and associated taxes.

I mentioned before about 11% of in-the-money stock options expire and also how there is no risk for you with stock options. In-the-money is when the stock price has increased above the exercise price when you were awarded the options. In our example it was an exercise price of $20 and the stock was worth $35 when you actually exercised it. So, this was in the money by $15. You certainly can choose not to exercise stock options that are in the money and let them expire, but I wouldn’t recommend being part of the 11%. Now, if the stock price drops below the exercise price you do not have to exercise your options as it would be cheaper to buy the company stock on the open market. Again, your exercise price is $20 and the stock drops below this value to $15 and never recovers before the options expire. You have no risk either way. If the stock appreciates you technically do not own the stock until you exercise the options and if the stock drops in value, well, why would you spend more than the stock is worth?

Finally, we are going to talk about the two types of stock options. Non-qualified and Incentive Stock Options. Non-qualified are the more common type of options. I heard recently 95% of options are non-qualified. The non-qualified simply means these options do not meet any rules to qualify for special tax treatment. 

When you exercise non-qualified options you will have to deal with taxes. Sorry. A term to become familiar with is compensation income. This is the difference, or spread, from your exercise price and the actual stock price when you exercise. In our example it is the difference between $20 and $35, or $15. The IRS treats this as ordinary income and you have to pay taxes on it that include Income Tax, Social Security and Medicare. Down the road when you sell the shares any proceeds above or below the $35 price will be taxed at capital gains and losses rates.

Now, let’s talk about incentive stock options, the less common form of stock options. ISOs as they are known do qualify for special tax breaks where they can avoid income, social security and medicare taxes. Only employees can be granted ISOs. So, if you are a consultant or a contractor and you are wondering what kinds of stock options you have been awarded, well odds are really high you have non-qualified ones. 

A couple of other unique rules with ISOs. First, there is a $100,000 limit on the aggregate grant value of ISOs that may vest and therefore become exercisable in any calendar year. Also, if you leave your employer and want to take advantage of the special tax treatment of ISOs, you must exercise your ISOs with 3 months. 

The last thing I want to cover is after you exercise the ISOs you must hold the shares for more than two years past the grant date and more than one year from the exercise date to get the benefit of long-term capital gains rates on gains above the exercise price. Going shorter than these time periods results in ordinary income rates. 

A quick warning about AMT, alternative minimum taxes. Paper gains on ISOs held beyond the calendar year where you can exercise could subject you to AMT. That is one thing, but worse is if you are hit with the AMT on theoretical gains but the company’s stock price then drops. You are holding a big tax bill on income that has disappeared. 

Thanks for sticking around to get through the basics of Stock Options. We’ll keep talking about equity compensation as I cater to clients with equity compensation so they can do the things they want in retirement.