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Employee Stock Options: The Basics

Nov. 26, 2013
Investing
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By  Laura Tanner, Ph.D, CFP® 

Learn more about Laura on NerdWallet’s Ask an Advisor.

This is the second in a series on how to benefit from equity in your company.  In Part 1, the basics of long-term incentive plans were discussed, along with vesting requirements.

Employee stock options can be a difficult concept to grasp.  The thing to remember is that there is the potential for great reward – down payment for a home, college tuition for your children,  early retirement.  You might have inertia because of uncertainty on how to proceed.  To quote Hunter Thompson, “A man who procrastinates in his choosing will inevitably have his choice made for him by circumstance.”

What are employee stock options?

They are the right (not the obligation) to buy shares in your company at a predetermined price, called the exercise price or strike price.  As discussed in the previous post, your ability to exercise these options is dependent on the vesting schedule (conditions you must meet, typically length of employment with company).

Here’s a hypothetical example, illustrating the potential for gain:

  • Your Option Price: $0.20
  • Fair Market Value on Exercise Date: $10
  • Number of Shares You Exercised: 5000

Note that the shares were ”in the money” – their value at the exercise date of $10/share was greater than the price you paid for them, $0.20/share.  The bottom line: you have $50,000 worth of stock at the time of exercise, at a cost to you of $1000.

This gain is hypothetical (i.e. unrealized gain), and only becomes real when the stock is actually sold.  In addition, taxes will be due (amount and timing dependent on the kind of stock options you have, incentive versus nonqualified).  When you exercise options and hold the stock, there is no guarantee of future gains or any gains (and the stock may even drop below the price you paid for it).

It is recommended that you seek professional advice in planning for the exercise and sale of your company stock, and in mapping out tax liabilities.

Three steps with employee stock options

  1. Vesting – schedule set by the company stock plan.
  2. Exercising – you can only exercise (pay the option price for) stock options which have vested.  The decision on when to exercise your options is complex, but at minimum the options should be “in the money” (value of stock at exercise > option price).
  3. Selling stock – at your discretion, factoring in investment goals, outlook for company stock performance, need for diversification, taxes.

Don’t lose track of your stock options

Stock options typically expire 10 years from the date of grant.  It is important to be familiar with the details of your company stock plan.  The company does not have to let you know when your options are close to expiration.

When you leave a company, you typically have 90 days to exercise vested options (check your company stock plan).  After that time, you have lost the right to those shares.