Stock Options Explained: Definition and Basics
Employee stock options (ESOs) have become a popular way for companies to recruit new employees and encourage current employees to stick around. When stock options are offered at your company, you can buy these shares and decide to hold on to them, trade them, or sell them.
If your company is successful, you may see a big profit from the shares you purchased. Stock options are one perk of employment that might pay off if you have patience and understand how they work.
Table of Contents
- 1 The Basics About Employee Stock Options
- 2 How to Exercise Employee Stock Options
- 3 Benefits and Drawbacks of Employee Stock Options
The Basics About Employee Stock Options
To take advantage of ESOs, you’ll need to understand put and call options. Put and call stocks are derivative, which means their value is determined by another financial product, referred to as the “underlying.” If a trader expects the price of the underlying to increase within a certain timeframe, they buy a call option. If the trader expects the price to decrease, they purchase a put option.
With a call, the trader is buying to invest and with a put, the trader is selling because the value is expected to decrease. In the U.S., buyers can purchase call or put options at any time up until the expiration date. However, European buyers can only purchase call or put options on the expiration date.
Employee Stock Options
Employee stock options are benefits provided to employees by their employers. ESOs are commonly offered to start-up company employees, since these businesses have room to grow and stock options may increase exponentially if they’re successful.
When you purchase stock options as an employee, they’re sold to you at a fixed price, called a strike, which is usually discounted from regular market price. Your employer sets rules on when you can begin to sell (or “exercise”) your shares, called a waiting period. Once the waiting period is over, you may sell or trade your shares as you wish.
Stock Option vs Equity
Stock options and equity are sometimes used interchangeably, which is correct. ESOs are a type of equity offered to employees. When stock is sold to employees, these employees own a small piece of the company, called equity. Stock is equity that’s traded and equity refers to the ownership of assets after debt is paid off. Both of these terms essentially mean having ownership in an entity or company.
Other Important Terminology
To understand and capitalize on your ESOs, it’s important to understand the terminology associated with these shares. Terms you should be familiar with include:
- Grant price: The price at which stocks can be acquired under a stock option plan.
- Issue date: The date on which a company issues its securities to the public, also called the offering date.
- Market price: The current price an asset can be bought or sold at.
- Vesting date: The date on which you can exercise your stock options according to the agreement you have with your employer.
- Exercise date: The date on which you make use of the right specified in your contract to either put or call.
- Expiration date: The last day you have to exercise your stock options, as outlined in your contract with your employer.
How to Exercise Employee Stock Options
When you decide to exercise your ESOs, it’s important to understand the process, your options, and the potential taxes associated with your transaction.
To exercise your stock options, you must buy your shares at the current exercise price. Your employer will give you a timeframe to exercise your stock options, or to cash in your stock options to shares. You can pay cash to exercise these options or sell enough shares during the transaction to cover the costs.
If your exercise price is lower than the stock price listed on the market, it’s a good idea to exercise your stock options since you’ll make money. Once you exercise these options, the shares you purchase are yours to keep. You may sell them on the market at any time, preferably once they’ve increased in value.
Managing Your Portfolio
When you add employee stock options to your portfolio, it’s important to be able to diversify your shares. Having all your investment money tied up in one company is never a good idea. If something were to happen to your employer’s stock value, not only may your employment be affected, but your investments as well.
Most financial advisors suggest not tying up too much of your personal wealth in your own employer’s stocks. Experts warn you should avoid having more than 10% to 15% of your portfolio tied to one company.
You might hold employer stock in your retirement accounts, taxable brokerage accounts, or employee stock purchase plans. Consider the leverage, or the amount of value compared to the personal investment you’ve made, in these stocks. Sell the stocks that are low-leveraging and hold onto the ones that are high-leveraging.
How to Value Stock Options
Since values fluctuate, there’s no way to value your stock options precisely. However, there are methods for understanding the value of your stock options, such as reviewing:
- Current 409A price: A 409A valuation is an independent appraisal completed by a company and filed with the Internal Revenue Code (IRC). All companies that offer equity must submit a 409A that provides values for common shares.
- Latest preferred price: This is the last price investors paid per share in the latest preferred round, or when the company offered public stock.
- Company valuation: The company valuation is what the company is estimated to be worth.
If you know the value of the company, take the company’s value, divide it by the number of outstanding shares, then multiply by the number of stock options you have. This will give you an estimate of your stock’s value.
You’re usually responsible for paying taxes when you exercise or sell your stock options. The two different types of stock options, non-qualified stock options (NQSOs) and incentive stock options (ISOs), are taxed differently. With NQSOs, taxes are usually withheld from your proceeds when you exercise your options. The profit you make is taxed as earned income.
With ISOs, if you exercise your stock options and sell your shares in the same year, you’re responsible for paying taxes on your profit at the regular income tax rate. If you hold onto the shares for longer than a year, when you do sell them you may be subject to long-term gain taxes on your profit.
Benefits and Drawbacks of Employee Stock Options
When you exercise employee stock options, you’re investing in the stock market so there are no guarantees you’ll make a profit. However, the price of the shares remains static based on the market price at the time you exercised the options. Therefore, if the market increases over time, you’re bound to make money.
There’s always the likelihood that your company stock will plummet, leaving your stock options worthless. The unpredictability of the market is both a benefit and drawback of your employee stock options.
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This post was updated December 12, 2019. It was originally published December 12, 2019.