Employee Stock Options – The Beginner’s Guide Part 1
In the startup world, getting ownership in the company you work for can be a significant part of your compensation package. Employee stock options are a form of this ownership value. It can appreciate dramatically as the company grows and may even turn into cash in your pocket when the company exits. On paper, that all sounds great and simple. In reality, however, the options world can get complicated and overwhelming. Don’t worry, we’re here to help you with that! This post will be the first step.
What Is A Stock Option?
Having stock options in a company means that you have the right to purchase shares of the company at a future time. It’s important to note that when you hear “exercising your options” it means the same thing as purchasing shares of the company.
To be clear, you’re an option holder until you exercise your options. After you have exercised your options, you are a shareholder in the company.
How Do You Get Stock Options?
Startup companies often give stock options as a part of their employee compensation packages. Stock options are often a way for companies to accomplish a couple of objectives. One objective is to attract and retain top talent. A company granting stock options to employees is sending a signal that the company wants to increase in value and it believes its hires will work hard to help achieve that increased value. Another objective is keeping fixed costs – like salaries – low in the initial stages of growth when cash flow is tight.
Employees with stock options sign an agreement when first hired – usually called something like a ‘stock option agreement’. This document is a legally binding contract between you and your employer. The front page of the agreement probably has several terms that you aren’t familiar with… yet. We’re here to help you get familiar with these terms that are important to your financial future!
Understanding Your Stock Options Agreement
If you look at your stock options agreement you probably see a few terms that could make you want to stuff the document into a drawer and promise to look at it another day. Not today! Let’s dig in.
- Exercise: No fitness equipment required! In this context, exercising your options means purchasing your options, which would then convert into shares.
- Grant Date: The date you signed your stock option agreement.
- Exercise Price: What it will cost you to buy one share of the company. It’s a predetermined price that is set when the option is granted to you. The exercise price remains fixed throughout the life of the option. It is set to the Fair Market Value of a common share of the company at the time the option is awarded.This means that different employees receiving options at the same time will typically get options with the same exercise price, but options with different grant/award dates (the day you got your stock options) could have different exercise prices.
- Vesting Commencement Date: The day the clock starts ticking on your vesting schedule, typically the same as the grant date.
- Vesting Schedule: Timeline for getting full ownership of your options.
- Post Termination Exercise Period: the amount of time (usually 30 to 90 days) an employee can exercise their options after they leave the company. . So, when you’re thinking about your “true” effective exercise period, it’s really the earlier of 10 years from grant or within 30-90 days of leaving the company.
What Is The Vesting Period?
Employees usually earn their options simply through the passage of time, the length of which is predetermined by the company and detailed in the stock option agreement. This period of time is called the vesting period. While vesting periods can vary, a common vesting period is four years.
Let’s look at an example. You’re granted 1,000 stock options the day you’re hired for a startup with the standard vesting period of four years with 25% of options vesting at the one-year anniversary (referred to as “the cliff”), and the remainder over the following three years, monthly or quarterly . Therefore, 250 options vest after the first year, then 62.5 options vest every quarter.
So far so good? Scroll down to the second part of this post, where we dive deeper into the meaning of exercising your shares and what happens next!
This vesting thing can get really confusing, really fast! Let’s take a closer look.
Exercising Your Employee Stock Options
Remember, as a stock option holder, you do not yet own a piece of the company. To become a shareholder, two things must happen with your employee stock options:
- They must vest. As soon as they do, you now truly own something. However, that something is still just the right to acquire shares of the company.
- You must exercise them. The right to ownership turns into true ownership only if you pay for it.
Exercising an option simply means acquiring shares of the company at the predetermined exercise price and according to the company’s option plan.
Let’s assume you started working for a company called FuzzyBear Inc. (a very promising startup) on January 1, 2017 and were awarded 8,000 options with an exercise price of $0.50 and a typical vesting period of four years as described above. It’s now April 1, 2018 and you’d like to exercise your vested options. That’s going to cost you. But how much? 2,500 options have vested (25% of 8,000, or 2,000 shares, after the one-year cliff, plus another 500 for the first quarter of the second year). To exercise each of them you must pay $0.50, which brings you to a total $1,250. $1,250 and you’re now a shareholder and on your way to stardom! Not so fast. You may have to pay some taxes and carry some additional costs to become a shareholder, which brings us to the next point – the different types of options (stay tuned for a full post dedicated to this topic)
What Happens After You Exercise Your Employee Stock Options?
You are now the proud owner of 2,500 shares in your company. Let’s assume you never exercised another share, left the company and have no additional options. It’s been 4 years since you’ve left and the company was just sold in an all-cash deal for $20.00 a share. What does that mean for you?
It means that you got $50,000 for your 2,500 shares (you paid $2,450 for those – not bad!). Does this all go into your pocket? Sadly, no.
Since you have already paid taxes on the increase from $0.50 to $2.00, you only have to pay taxes on the additional increase (since you exercised/bought them) from $2.00 to $20.00. Seems fair enough.
More good news: this increase is not taxed at your ordinary income rate but at a lower capital gains rate.
This is only Part I of The Beginner’s Guide. In future posts, we’ll dig deeper into each of the topics covered above. That way you will have a full understanding of options and how they work. You will learn how your decisions today can impact how much money you’ll make on your stock options in the future.
[This is not intended to be a comprehensive guide. We just want to give you a head start as you venture into the stock option world. Please consult your tax advisor as you make your decisions on how and when to exercise your options. Good luck!
 This value is determined using an independent valuation following section 409A of the tax code. We’ll write about that (and all the problems around it) in later posts.
 A few companies have moved to longer PTEs, but 30-90 days is still the most common PTE out there.
 If you’re an executive, you may have an acceleration clause in your vesting schedule, that could accelerate the vesting of a portion or all your options if the company is acquired and you are terminated (double trigger acceleration), or just if the company is acquired (single trigger).