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?
A stock option gives its holder the opportunity to acquire company shares in the future. The price of the stock option is a predetermined price that is set when the option is issued. It is a right to buy a share, and until you exercise this right, you are not a shareholder. This predetermined price is referred to as the exercise price or strike price. It is set at the time the option is awarded to the employee (the grant date) and remains fixed throughout the life of the option and until the option expires. It is simply the price that the option holder must pay to turn an option into a share. 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 strike price, but options awarded on different dates could have different strike prices.
How Long Is The Exercise Period?
Every option has an exercise period, including your employee stock options. This period is the time window in which your options can be exercised before they expire. The period is outlined in the company’s stock option plan and is generally the same for all company employees – most options expire 10 years after they were granted. Stock option plans also include a Post Termination Exercise period , or PTE. The PTE is the period employees get to exercise their options after they leave the company (voluntary or not) and it is typically set to 30-90 days. So, when you’re thinking about your “true” effective exercise period, it’s really the earlier of 10 years from grant or 30-90 day of leaving the company.
How Long Is The Vesting Period?
Employees usually earn their options over a vesting period. That means they get their options simply through the passage of time following the grant date, as long as they are still with the company. The standard vesting period is 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. Again, receiving an option award from your employer is not the equivalent of receiving shares. Meaning, 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.
(Note – Both conditions need to occur. Some companies allow early exercise, so the order in which the conditions occur does not have to be sequential. More on early exercise in a later post).
Exercising Your Employee Stock Options
Exercising an option simply means acquiring shares of the company at the predetermined exercise price and according to the company’s option plan. Example time! Let’s assume you started working for a company called FuzzyBear Inc. (very promising startup) on January 1, 2017 and was 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.
Different Type Of Options – ISO vs. NSO
We’ll have a full post dedicated to this topic, and it’s going to be a fun one. We’ll keep it brief for now. Employees typically get one of these two types of options – incentive stock options (ISO) or non-qualified stock options (NSO). From an employee standpoint, the main difference between these two types of options can be summarized in one word: taxes.
- When you exercise an ISO, it is very possible that you will not have to pay federal tax.
- When you exercise an NSO, it is very possible that you will have to pay federal tax at the ordinary tax bracket (whatever yours is) and be subject to additional federal and state withholdings. The tax is calculated on the difference between the Fair Market Value of the share at the time you exercise your options and the strike price. In other words, you are taxed on the increase in the value of the shares from the time your options were awarded to the time you choose to exercise them.
Let’s go back to our example from above. Let’s assume that in the 15 months since you joined the company, the fair market value of shares increased from $0.50 to $2.00. Let’s also assume your options are NSOs. In this case, you not only have to pay $1,250 for the cost of exercising your options, but you also must pay taxes on the increase in the value of the shares. Basically, the IRS is telling you – ok, you got something that’s worth $2.00 but you’re only paying $0.50? We’re going to tax the $1.50 difference as if it was just another part of your paycheck. Let’s assume your total federal + state + withholding rate adds up to 32%. We’re talking about another $1,200 (2,500 shares x $1.50 x 32%) to cover just taxes. That basically doubled your cost from $1,250 to $2,450. The difference between ISO and NSO taxation does not end here. That difference may also impact your tax bill when you eventually sell your shares.
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 get $50,000 for your 2,500 shares (you paid $2,450 for those – not bad!).But it also means you have to pay more taxes. 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 from $2.00 to $20.00. More good news: this increase is not taxed at your ordinary income rate but at a lower capital gain rate. If this was an ISO and not an NSO (and assuming you did not trigger any tax at the time of exercise), you would have paid the lower capital gain rate on the entire $0.50 to $20.00 00 increase.
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 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)  Unless you are a high earner that triggers the Alternative Minimum Tax (AMT)  The new tax bills may allow you to defer the federal tax payment (not the other withholdings) for a period of 5 years, but those will still be payable so you’re still incurring a liability  Assuming this is a qualified disposition – more on that in later blogs.
All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors.