Stock Options Explained

Let’s take a look at what stock options are, discuss important issues relating to exercise periods, and explain a highly effective way in which anyone who holds options can sell them.

In this article, we’re going to discuss:

• What is an ESO?
• What is an exercise period?
• What is the takeaway from this?
• Stock option taxation in relation to employees upon exercise
• When to exercise at PPS over the exercise price
• Selling can be complex – Get expert guidance and assistance

What is an ESO?

An ESO (Employee Stock Option) is referred to as a form of equity compensation. ESOs are granted to executives and employees by companies. By doing so, companies are not directly granting shares of stock, instead, they are giving employees derivative stock options.

Such options include regular ‘call options’ and give employees the opportunity (and right) to buy company stock. This ‘call’ will be at a stated price and for a fixed period of time. The terms and conditions for employees will be fully described in what is known as an ESO agreement. This agreement should be signed by both parties before employment commences.

What is an exercise period?

The exercise period is also known as an exercise window. This is the period at which shares can be purchased at the strike price. The strike price is classed as the agreed, contracted stock price and allows the holder of the options to sell or buy a stock.

One particular point relating to exercise windows is something that needs to be understood clearly: The exercise period is only valid until the stated expiry date.

As long as the person remains working for the company in question for an agreed amount of years this fixed period of time is typically between 7 and 10 years with 10 years generally being more common.

However, if employment is terminated (either by the employee deciding to leave the company or are dismissed) the expiration date is often 90 days after the termination of service. If an employee cannot exercise before this point the reality is that the options are effectively worthless.

We will shortly get into details of when options can be exercised. But before that let’s touch a little more on expiration after termination. The length of exercise windows upon contract termination has (and still is) a long-debated point.

While the 90-day ‘rule’ is still prevalent, some companies are introducing exercise windows that stay open for years after an employee has left the company. There are arguments for and against extending exercise windows.

Some are of the belief that extended exercise windows will be the future. Their stance is that in terms of a company’s success, keeping a shorter window is a punishment for early employees who have strived to get the company on their feet at lower salary levels than normally would be expected.

On the other hand, there are two common arguments against extended exercise windows. In the first instance, some companies and investors maintain this short exercise period works as an incentive for employees to remain with the company. Secondly, they feel that the introduction of a long window is, in effect transferring wealth from those employees who commit to long-term service to those who leave early.

What is the takeaway from this?

To avoid any misunderstanding on the length of exercise windows upon contract termination this matter both founder(s) and employees need to clearly flesh out the matter before the signing of any employment contract offer is agreed and signed.

When can I exercise stock options?

To explain when stock options can be exercised let’s take an example.

As part of your contract package, you are given 40,000 shares of company stock. The agreed conditions of this deal state that there is a 4-year vesting period with a 1-year “cliff”.

This means you will have to wait for 4-years before having the right to exercise the full 40,000 shares. However, these options are staged and will vest gradually over the agreed vesting period, but not immediately.

The 1-year cliff means that you must stay with the company for at least 1-year. Leaving the company before you reach the 1-year milestone means you will get no options.

Once you have exceeded the cliff period of employment it is common for one-quarter of your options to vest each year. In this example that is 10,000 options each year. So, by staying with the company for 1 full year you will have exercise rights on 10,000 options, for 2 years, 20,000 options, for 3 years, 30,000 options, and after completion of your 4th year of employment, you have exercise rights on the full 40,000 options.

After your first year’s employment your remaining options are likely to vest so that you receive equal monthly amounts for the remaining 3 years (36 months). 36 months divided by 30,000 options means about 833 options will be vested each month.

Assuming you remain employed by the company it is possible to exercise your options once they are vested until the stated expiry date. As mentioned, the expiry date is typically 10 years.

However, understanding the best time to exercise your options during this 10-year window comes with many considerations. Just 4 examples are:

• Is your company private or public?
• Do your options have value?
• Does it fit with your current financial situation?
• Does it make sense tax-wise? 

And, with the last point in mind:

Stock option taxation in relation to employees upon exercise

The two main types of stock options issued by an employer to employees are:

• ISOs – Incentive stock options. These are also called qualified options or statutory options.
• NSOs – Non-qualified stock options. These are also called non-statutory options.

It will depend on the type of stock options employees own as to the varied tax treatments that need to be addressed such as:

• Ordinary income tax.
• Capital gains tax.
• Alternative minimum tax (often abbreviated to AMT).

On top of this employees should assess how any stock options sales fits with their financial goals and any income needs. This will help when considering any tax implications for exercising options and whether to hold onto company shares before selling.

Any ISOs or NSOs that are sold without a qualifying disposition will usually see the bargain element of stock options taxed at the income tax rates set during the year of exercise.

What is the case if your income for that year means you are already in a high-income tax bracket or if any additional income received from selling stock options will push you into a higher income tax bracket?

You should then consider delaying the exercising of your options. Alternatively, forecast ahead and spread your exercise options over a few, potentially lower tax years.

Concerning ISOs that come with a qualifying disposition, no tax is levied upon exercise. You will only be taxed in the event you sell your company shares. For those employees who are holding company shares with a view to receiving favorable tax treatment, the bargain element here could trigger AMT (Alternative Minimum Tax).

When to exercise at PPS over the exercise price

PPS stands for Price Per Share and once your options are vested you are at liberty to exercise them. What this means is you can buy shares of your company stock. Until you commit to exercising, these options have no real value.

When you do decide to exercise, the price you will pay (as agreed when joining the company) is referred to as the exercise price, grant price, or strike price. Regardless of how well (or how poorly) your company does, the exercise price does not change.

Keeping with the above example and assuming your 4 years of employment have elapsed you now have 40,000 stock options available. Let’s assume that the agreed exercise price at commencement of employment was $1. If you wish to exercise all 40,000 of your options that will cost you $40,000 (40,000 x $1).

Once exercised you own that stock and are free to sell it. Alternatively, you can hold on to it in the hope the stock price rises. Do bear in mind that there are fees, commissions, and taxes associated with exercising and selling options. 

What if you do not have the ‘ready’ cash to exercise your options but still want to? Those employees who want to exercise their options without the need to use their own money do have options.

Two common ways are:

• Exercise-and-sell transaction: This means you purchase your options and sell them immediately. By doing this it is the brokerage service handling the sale who effectively puts the money up for you. They will use the money made from your exercise sale to cover what it costs you to purchase the shares.
• Exercise-and-sell-to-cover transaction: This approach means you sell just the amount of shares to cover your share purchase and hold the rest.

When looking to exercise your stock options there are times that this can (or should) be carried out. Here are 3 for consideration:

Imminent expiration

This is very straightforward. Having confidence in your company means it is always better to exercise than allow those hard-earned options to disappear for nothing. However, if you are still with your company but are planning on leaving or fear your job may be lost then consider exercising your options as this will ease the pain of your exit.

Those who have already left the company need to clearly understand how long they have before option expiry. Refer to the above “What is an Exercise Period?” section for details on potential expiry timescales. There is a clear incentive to exercise before expiry otherwise you will lose all value.

Exercising early

While it is not the case with all companies, if an early exercise of unvested options is available to you it could be advantageous to exercise stock options early. This is if you have faith in your company and you have the cash (or the ability to raise the required sum!)

Two benefits here. First exercising early will very likely have no (or very little) tax liability at the time of exercise. Second, you are giving yourself a head start in terms of long-term capital gains for options that you have not even vested.

An added bonus here is that a lower long-term capital gains rate will be applied to the vast majority of your stock gains. This is opposed to (for NSOs) having to pay income tax, or (for ISOs) being liable for AMT on ‘phantom’ gains if exercising once your options become vested.

Reducing taxes

You have numerous ways in which to reduce stock option taxes. Reducing any tax impact has to be seen as a strong motivator when it comes to exercising stock options.

This can relate to long-term capital gains tax and exercising before 409A goes up. The 409A valuation is also known as ‘fair market value’ and is classed as a value appraisal of a company share for tax purposes. When an employee pays taxes on their equity compensation the amount owed is 409A based.

Selling can be complex – Get expert guidance and assistance

It is clear that there is a lot involved when it comes to stock options and exercising your rights. This makes it imperative that you maximize your opportunities.

To do this it is strongly advised that you take advantage of a company with intimate knowledge of the startup business arena.

WOWS Global is one such company. We bring together a community of expert talent to provide individuals, investors, and companies with a wealth of services tailored to their personal needs.

Leveraging maximum financial benefit for yourself from those hard-earned stock options is an absolute must. Our ethos is that you should have the freedom to sell your rightfully earned stock options according to your preference. WOWS Global is committed to uncovering and maximizing value for you.

Not being aware of when it is exactly the right time to sell and when to wait could cost you dearly. The highly-experienced team at WOWS Global can ensure that you take full advantage of your individual situation and needs.

Our high-tech, online systems are state of the art to give you everything required to manage your assets to maximum effect. To add to this you will have access to expert personal planning and financial advice that will address any questions you have.

Selling your stock options is not something you should do lightly. When the opportunity is right WOWS will be in the strongest position to advise and guide you through the complex world of stock options.

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To find out more, visit our ESOP Services page or schedule a no-obligation chat with one of our experts today to discuss how we can assist with your company's ESOP needs