What are stock options, and how do you exercise them?
Have you ever wondered how some people seem to get rich by working for startups or tech companies? Chances are, they benefited from something called stock options. Stock options are a way for companies to compensate employees, especially when the company isn't flush with cash. Instead of paying high salaries, they offer the option to buy shares of company stock at a discount. If the company does well and the stock price goes up, employees can buy shares at the lower price and sell them for a profit.
Not a bad deal, right? Stock options are a gamble, but they can be very lucrative. The key is working for a company poised for growth. Of course, the stock price could also go down, leaving options worthless. But with the potential for a big payout, stock options attract top talent. If you've ever dreamed of striking it rich, understanding stock options is key. Let me break it all down for you so you can decide if those options offers are worth negotiating in your next job.
What are stock options?
Stock options are a perk some companies offer employees as part of their compensation package. They give you the chance to buy company shares at a discount. The idea is to give you an incentive to stay with the company and work to increase the stock price.
If the company does well and the stock price goes up, you can buy shares at the cheaper option price and then sell them for a profit. For example, if you're granted options with an exercise price of $30 per share, and the stock price rises to $50 a share, you can buy at $30 and immediately sell at $50, pocketing the $20 difference.
The two most common types of stock options are:
- Incentive stock options (ISOs): Only available to employees. Offer tax benefits if you hold the shares for at least a year after exercising your options.
- Non-qualified stock options (NSOs): Available to employees, contractors, and board members. Fewer restrictions but you have to pay income taxes on the discount when you exercise your options.
Stock options are a gamble, but if the company succeeds, they can be very rewarding. The key is understanding how they work so you can make the most of this potentially lucrative employee benefit.
How Do Stock Options Work?
So how exactly do stock options work? Basically, your company gives you the opportunity to buy company stock at a discounted price.
When You're Granted Options
- Your company will grant you a certain number of stock options as part of your compensation package. This gives you the right to buy company stock at a set price, called the strike price, on a specific date.
- The options usually vest over time, meaning you earn the right to exercise part of the total options each year. For example, your options may vest over 4 years, allowing you to earn 25% each year.
When You Exercise Your Options
- Once your options vest, you can exercise them - meaning you can buy the stock at the strike price. If the current market price is higher than your strike price, you get an instant profit!
- To exercise your options, you notify your company, then purchase the stock at the strike price. You can hold onto the stock or sell it right away for a gain.
- You must pay income taxes on the difference between your strike price and the market price. But if you hold the stock, you can potentially make even bigger gains over time as the stock price climbs.
Stock options are a great way to have ownership in your company and share in its success. Make sure you understand the rules around vesting and exercising so you can take full advantage of this valuable employee benefit.
What are the different types of stock options?
There are two main types of stock options:
Incentive stock options (ISOs)
Incentive stock options are options granted by a company to its employees. They allow you to buy company stock at a fixed price within a certain period of time. The main benefit of ISOs is that any profit you make from exercising the options and immediately selling the shares may qualify for capital gains tax treatment. This means the profit could be taxed at a lower long-term capital gains tax rate versus regular income tax rates.
Non-qualified stock options (NSOs)
Non-qualified stock options are options granted by a company to employees, directors, and contractors. They also allow you to buy company stock at a fixed price within a certain time period. However, the bargain element—the difference between the grant price and the market price at exercise—is considered taxable income in the year you exercise the options. Any gain or loss from then selling the shares would be subject to short-term or long-term capital gains tax rates depending on how long you hold the shares after exercising the options.
The specifics of how stock options work at a particular company are outlined in that company’s stock option plan documents. Make sure you understand the details of any options offered to you before exercising them. Stock options can be an attractive employee benefit, but you want to go in with your eyes open to the potential tax implications and risks involved.
What is a stock option grant?
A stock option grant is when your company gives you the chance to buy company stock at a fixed price for a certain period of time. Typically, the fixed price is the stock price on the day the options are granted to you. This allows you to buy shares later on at that locked-in price, even if the stock price has gone up significantly.
How Does It Work?
Say your company grants you 1,000 stock options with an exercise price of $10 per share. Over the next few years, your company's stock price rises to $25 per share. With your stock options, you can buy 1,000 shares at the $10 exercise price, then turn around and sell them for $25 each, netting a profit of $15,000! The longer the time period your options are valid for, the bigger the potential gains if the stock price rises.
Stock options are a way for companies to attract and retain top talent. They give employees the opportunity to share in the company's success and reap financial rewards. Options also motivate employees to work hard to increase the company's stock value. It's a win-win - if the stock goes up, both the company and employees benefit.
The details of your company's stock option plan, like when options vest (become available to exercise) and when they expire, are outlined in their plan documents. Make sure you understand all the particulars so you can take full advantage of any stock options you receive. With the potential for a big payoff down the road, stock options are one of the most compelling benefits a company can offer.
Exercising and selling stock options
Once your stock options have vested according to the schedule laid out in your option agreement, you have the right to exercise them. Exercising stock options means purchasing the shares of stock at the strike price. Usually, you have a window of time, often up to 10 years from the initial grant date, to exercise vested options before they expire.
How to exercise stock options
Once your company's stock options have vested, it’s time to think about exercising them. Exercising stock options means purchasing the stocks at the price set when they were granted to you, also known as the strike price. This allows you to buy company shares at a discount.
To exercise your vested stock options:
- Review your stock option agreement to determine how many shares you can purchase and the deadline to exercise them. The deadline is typically 10 years from the grant date.
- Check your company’s stock price. If the current stock price is higher than your strike price, exercising your options could lead to an instant profit. If the stock price has declined, you’ll have to determine if you still want to purchase the shares.
- Contact your company’s stock plan administrator, usually in the finance or HR department, to begin the exercise process. You will have to provide payment for the total strike price of the shares you want to purchase.
- The stock plan administrator will provide you with the necessary exercise forms to complete. Once submitted and payment has been received, the shares will be deposited into your brokerage account.
- Decide whether to hold onto the shares or sell them. If you sell right away, you lock in your profits. If you hold, the shares could gain (or lose) value over time. Many people sell some shares to take profits and hold some for long term growth.
Exercising your stock options is an important step to take advantage of the opportunity provided by your company. With some planning and analysis of the risks and rewards, you can make the choice that suits your financial goals. Be sure to also consider the tax implications to minimize your obligations.
How to calculate what your stock options are worth
Once you have stock options as part of your compensation, you’ll likely want to know how much they’re worth and how that value can change over time. Calculating the value of your options involves a few factors:
Current stock price
The current trading price of the stock is the biggest determinant of your options’ value. If the stock price rises a lot after you get your options, they become much more valuable. If the price drops, so does the value of your options.
Option strike price
The strike price is the price at which you can buy the stock once you exercise your options. So if the strike price is $30 and the current stock price is $35, your options have an “intrinsic” value of $5 per share. The higher the stock price is above the strike price, the more your options are worth.
The more time left until your options expire, the greater the chance the stock price could rise and make your options more valuable. Options that expire in 5-10 years are usually worth more than those expiring in 1-2 years.
A stock that fluctuates wildly in price has high volatility. Options for volatile stocks are usually worth more than for stable stocks, because there’s a greater chance of a big price swing that boosts the value of your options.
So keep an eye on all these factors to determine if your stock options have become a valuable part of your compensation - or still have room to grow! With time and the right conditions, stock options could provide a big payoff. But there’s also a chance they expire worthless if the stock price never rises above your strike price.
How do stock options vest?
Once you've been granted stock options by your company, they don't become yours right away. Stock options vest over time according to the vesting schedule set by your company. This means you earn the right to buy or sell a portion of the options over time. The most common vesting schedules are:
- Monthly over 3-4 years: You earn 1/36th or 1/48th of the options each month.
- Annually over 4 years: You earn 25% of the options each year.
- Milestone based: Options vest when you achieve certain work anniversaries, performance goals, or other milestones.
As the options vest, you can exercise them to purchase shares of stock at the grant price. The grant price is the market price of the stock when you received the options. Once the stock vests, you can buy shares at that fixed grant price even if the market price has gone up since then.
Exercising vested options allows you to profit if the stock price rises over time. You can then hold onto the shares or sell them for a gain. Unvested options provide incentive for you to remain with the company until they vest. Leaving before they vest means losing the opportunity to benefit from them.
Stock options are a common way for companies to attract top talent by providing the possibility of a big payoff down the road if the company and stock price do well. But there is risk too, if the stock price declines or stays flat, the options may end up worthless. Understanding how options vest and exercising them at the optimal time is key to maximizing their benefit.
How do stock options work after termination?
After you leave a company, your stock options may still be valid and exercisable for a period of time. This is known as the “post-termination exercise period.” During this time, you typically have 90 days to decide whether to exercise your vested stock options by purchasing the shares.
If the share price has increased substantially, exercising your options could lead to a big payoff. However, if the share price has dropped, your options may be “underwater”— meaning the current market price is less than your exercise price. In this case, you’ll need to decide if you want to exercise in hopes the share price will recover and increase in the future.
The specific details of your post-termination exercise period will depend on the type of options you have and your company’s stock plan. It’s important to understand these details, like the exact number of days you have to exercise vested options after leaving and whether unvested options will continue to vest. Some plans may allow for an extended exercise window for “good leavers” like those who retire or are laid off.
Exercising stock options after termination can be complicated, so make sure you understand all the rules around your specific options and stock plan. If needed, don’t hesitate to ask your company for clarification or consult with a financial advisor. The decisions you make during this time could significantly impact your financial future.
Frequently Asked Questions About Stock Options
Stock options give employees the chance to own part of the company they work for. But how exactly do they work? Here are some common questions and answers about stock options:
What are stock options?
Stock options give you the right to buy company stock at a fixed price for a certain period of time. If the stock price goes up over time, you can buy shares at the lower option price and then sell them for a profit.
How do I get stock options?
Many companies offer stock options as part of an employee compensation package, especially for upper management and key employees. The options are typically part of your employment offer. You must work at the company for a certain period of time, known as the “vesting period,” before you can exercise the options.
When can I exercise my stock options?
You can only exercise vested stock options, meaning options you have earned the right to use based on your time working with the company. The specific vesting schedule depends on your company’s policy. Options often vest over 4 years, with 25% vesting each year. But some companies have different schedules.
Do I have to pay anything when I exercise options?
Yes, when you exercise stock options, you must buy the stock at the fixed price set by your option grant, known as the “strike price.” This can cost a few thousand to hundreds of thousands of dollars, depending on the number of options and strike price. Many employees take out loans to exercise options, hoping the stock price will go up enough to pay off the loan.
What happens if I leave the company before options vest?
Any unvested stock options are typically forfeited if you leave the company before they vest, unless your departure is involuntary, such as due to a layoff. Some companies may allow you to vest a portion of the unvested options, but that is relatively uncommon. So if you want to get the full benefit of your stock options, it usually pays to stay with the company through the entire vesting schedule.
So there you have it, a quick primer on stock options and how they work. While the topic can seem complex, the basic idea is quite simple. Stock options give you an opportunity to buy shares of stock in the future at a price set today. If the share price goes up a lot, you can exercise your options and buy the stock at a bargain. You can then turn around and sell those shares for a profit. Not a bad deal!
Of course, there is inherent risk since the stock price could decrease instead of increase. But with some research, you can make educated guesses about the direction a company’s stock may move. And if you receive options as part of your employee compensation, you have an opportunity to get in on the ground floor.
Stock options aren’t for everyone, but they can be a lucrative way to invest in and profit from the success of companies you believe in. So now that you understand the basics, you can determine if stock options are the right choice for your investment strategy. The potential rewards may just be worth the risk! For further details and support contact WOWS Global at email@example.com.