Updated October 15, 2023
Mike Zaccardi, CFA, CMT
Many workers today are compensated through employee stock options (ESOs). It can be a complicated maze to figure out what you own and how much your stock options are worth. Moreover, the tax consequences of earning and exercising options, then selling shares, is a common source of financial anxiety for employees.
Knowing all the terms and hoops to jump through can feel intimidating. Have no fear. We'll outline all the need-to-knows so you can build an understanding of ESOs and the confidence to make the best decision with your options.
What Is an Employee Stock Option?
Employee stock options are a popular way for many companies – particularly startups and tech-related firms – to compensate workers. In addition to the usual salary, bonus, and benefits package, ESOs are used to incentivize employees to work for the good of the company. ESOs are granted to regular employees and executives rather than shares of stock.
For background, options offer holders the right but not the obligation to purchase shares of stock at a predetermined price at some point in the future. Thus, ESOs are generally call options with a limited life, or an expiration date. If you are paid via ESOs, you can always review the terms of your contract or reach out to your Human Resources department to get a better grasp of what you own.
Encouraging a Workforce Through Equity Compensation
You might wonder how ESOs encourage everyday employees and the top management team to work harder and better for the good of the company. Think of ESOs as the carrot dangling in front of the horse – the more sales and profits an enterprise earns, the more likely it is that it will be valued higher. That means a bigger share price. Stock options, with a relatively low exercise price, can then become incredibly valuable.
ESOs are not your typical stock option, though. For instance, an ordinary investor cannot simply go to the market and buy the same options that employees of a startup company own. So, they are not “exchange-traded” options.
It’s also important to know that there are other types of equity compensation, including restricted stock units (RSUs), stock appreciation rights (SARs), phantom stock, and employee stock purchase plans which are common even with large, mature companies.
Equity compensation is a means to get all workers to have skin in the game and share in the success, and even possible failure, of the company.
Stock options are perceived as being worth their weight in gold should a hot startup make it all the way to the exit stage via an Initial Public Offering (IPO). During an IPO, it’s common for a firm’s stock price to soar to new heights, making early owners quite wealthy – particularly those who had held ESOs for a lengthy period and locked in a low exercise price.
Types of Stock Options
If you find yourself owning stock options through your job, chances are they fall into one of two categories, or maybe both.
Incentive stock options (ISOs): Also known as qualified or statutory options, ISOs are often restricted to just key employees or those on a firm’s top management team. This type of equity compensation features preferential tax treatment if certain conditions are met. Gains from the sale of stock after exercising the ISOs can be potentially treated as a long-term capital gain rather than as regular taxable income.
Non-qualified stock options (NSOs): This type of stock option is made available to a broader array of workers, including members of a company’s board and even contract workers. As so-called ‘non-statutory’ stock options, profits derived from NSOs are generally considered ordinary income, so they are often taxed at higher rates than ISOs.
Key Terms to Know with Your ESOs: Vesting and Grants
Along with understanding ISOs and NSOs, it is important to know the terms of your contract at work and what might happen should you leave the company as it pertains to your ESOs. Your options could be canceled if you depart before the “vesting” date of the options.
The term “vest” simply describes when the options become the property of the employee rather than the company. It’s a similar concept to a 401(k) plan’s employer match vesting schedule. A long vesting schedule helps startup companies retain workers – if they simply doled out options without a vesting period, employees might just get up and leave!
It’s common for ESOs to vest in incremental amounts over time. For example, if you were granted 4,000 stock options, the first 25% might vest after one year with another 25% in each subsequent year. So, you would be able to exercise options starting one year after being issued, or granted, the ESOs. Finally, there could be a specific term over which you could exercise options to buy shares (the expiration date); after which you would no longer be able to exercise.
Before your options vest, though, they must first be “granted” to you, which simply means the company gives you the right to purchase its stock at a fixed price at some point in the future. This is when reading through the employer’s stock options plan is critical so that you know your rights as a grantee. An options agreement with the company outlines items like a vesting schedule, how ESOs vest, how much shares might be earned through a granting process, and the all-important strike price.
How To Value Stock Options
Exercising is a transaction term that simply means converting your options into shares of stock. Putting some numbers to that, let’s say you have 1,000 stock options with a strike price of $5. The stock price is worth $25. You would exercise at the $5 strike and receive 1,000 shares of stock that are worth $25,000. In essence, you profited by $20,000 relative to the $5 exercise, or strike, price. You could then sell the shares or continue to hold them.
The above example is a good illustration of how ESOs are valued. It is not as complicated as you might think! For more background on options, though, it’s vital to grasp the two factors that determine a stock option’s worth: intrinsic value and extrinsic value (or time value).
The intrinsic value is simply the difference between the stock price and the option’s strike price. Time value is the foggier factor – it is the amount of value an option has simply due to the time remaining to expiration. Think of it this way – the more time left in an option’s life, the bigger the chance it can soar to the moon and become extremely valuable. So: more time, more extrinsic value. That’s sometimes why a firm puts a limit on the timeframe over which you can exercise ESOs.
It’s not all rainbows and unicorns with ESOs, however. If a firm’s share price sinks and stays low, your options might be worth very little. That is one of the upshots for an employer – they can pay employees in stock options, and if the firm goes belly-up, the options effectively became a low-cost compensation method. On the bright side, if your options have no intrinsic value – when the stock price is far below the strike price – but there is ample time left until the options expire, the ESOs could still have significant time value.
How Are ESOs Taxed?
If you made a big score with your ESOs, congratulations! Now you must pay Uncle Sam his fair share. Not only can stock options be tricky to value at times, but tax implications are also difficult to navigate for those with complex situations. This is where many folks seek guidance so that not only do they pay the correct amount, but they also execute the best strategy. It’s all about maximizing the value of what you own while minimizing long-term tax liability and overall risk.
At the Grant Date
First, if you were granted ESOs, don’t sweat it – that is not a taxable event. Moreover, if you are a newly minted grantee, your options may not carry much of an embedded capital gain since it’s routine for a firm to price stock options with an exercise price near the current fair market value (FMV) of the stock. It is when you go to exercise that you must consider taxes.
At the Exercise Date
The first possible taxable event usually happens when you exercise ESOs. With NSOs, one of the two types of ESOs, you owe ordinary income tax on the spread between the exercise price and the stock price. With ISOs, though, exercising is usually not a taxable event, but there could be AMT (the Alternative Minimum Tax) impacts for some taxpayers.
At the Sale Date
Now let’s jump ahead to when you go to sell shares after exercising the options. With NSOs, the difference between the sale price and the stock’s FMV on the exercise date is taxed as a capital gain. With ISOs, there is a special tax break. Want to know more about it? Let’s detail the rules.
Qualifying and Non-Qualifying ISO Dispositions
If you own ISOs, you can minimize your tax bill by taking a “qualifying disposition” whereby you wait at least a year after the exercise date, or two years after the grant date, before selling shares. With that amount of patience, you earn yourself the reward of a lower tax rate in many circumstances. You pay long-term capital gains tax on the spread between the stock price and the exercise price. For those in a high marginal tax bracket, you might also face the AMT tax from the sale of ESOs.
A non-qualifying disposition happens when you sell shares within a year from the exercise date. You would then owe regular income tax on the spread between the FMV of the stock and the strike price if the ISOs were sold for a profit.
An Eye on Diversification
ESOs might seem complex enough, but it’s critical that you properly value them in relation to your overall investment plan. As the saying goes, you don’t want to place all your eggs in one basket. So, selling shares, then using the proceeds to diversify into other assets might be prudent. Also, consider that your livelihood is already invested in your employer through your job! At Allio, we believe in financial wellness for all, so viewing your portfolio holistically can be a good way to ensure you are diversified.
The Bottom Line
Equity compensation is not as straightforward as a simple base salary plus a bonus. Workers must know what they own and how they plan to go about turning ESOs into shares, then eventually have a plan for how to sell shares to generate cash. Grasping all the rules and understanding your company’s stock option policies is vital to making the most of your ESOs.
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