Employee Stock Options for Beginners
Employee stock options could be a pretty strange concept especially if you’re just getting into it. But what you should keep in mind is that it is it has the potential to reward greatly. It can also be great compensation for a not-so-great salary as well as a cool bonus on top of a nice salary.
But first, there is a need to understand the concept of employee stock options.
What are Employee Stock Options?
Employee stock options commonly referred to as ESOs refer to stock options in the company’s stock that are granted by an employer to specific employees. More often than not, only employees in management or officer-level positions are privy to this.
Stock options simply grant the employee the right to purchase a certain amount of shares of company stock at a specific price known as the grant or strike price and within a specific time period.
If this time period is exceeded without the stock options being exercised, it would be considered worthless since it has exceeded the expiration date. Similarly, ESOs have a vesting date and you cannot exercise your stock options before the vesting date as well.
Here are some of the terms associated with ESOs:
- Grant price/exercise price/strike price: this refers to the stated or specified price in your employee stock option plan at which you can purchase the stock.
- Issue date: this refers to the date when the stock option is given to you.
- Market Price: this is the current price of the stock.
- Vesting Date: this refers to the date that you can exercise your stock options in line with the terms of your employee stock option plan.
- Exercise Date: the exact date that you exercise your options.
- Expiration Date: this is the date that you exercise your options, otherwise they would expire.
Types of Employee Stock Options
There are two types of stock options that companies issue to their employees:
- NQs – Non-Qualified Stock Options
- ISOs – Incentive Stock Options
These options come with various tax rules of course. In the case of non-qualified employee stock options, when you exercise your options, taxes would most often be withheld from your proceeds.
This is not the same for incentive stock options. However, given the right tax planning, you could very well reduce the tax impact on the options you exercise.
How Do Employee Stock Options Work?
In order to understand how stock options work, it is necessary to consider an example.
For instance, your new company grants you stock options for 20,000 shares of the company’s stock. You would first of all need to sign a contract that includes a clear statement of the terms of the stock option; you may find this included within the employment contract.
The contract would contain the grant date which refers to the date that your options would start to vest; vesting refers to when all your stock options are available for you to exercise or purchase.
However, you would typically not receive all of your options immediately you join the company. Instead, the options vest gradually within a time period which is referred to as the vesting period.
If in this instance, the options have a five-year vesting period, it implies that it would take you working at that company for five years before you gain the right to exercise your 20,000 options.
This, however, shouldn’t stop you from knowing how much you are getting from your stock. Although your stocks would vest gradually during the course of these five years, you can still access a particular amount of your stock options before the five years elapse.
Going by this example, you could have one-fifth (4000) of your options vest every year for the five-year vesting period. Therefore, by the second year, you would have the right to exercise 8000 options.
However, there is a waiting period before any of your options vest, this waiting period is referred to as ‘the one-year cliff’. This implies that you would need to have been with the company for at least a year before you receive your options.
If you quit before the end of that year, you would not be entitled to any options. After the one year waiting period, you would get your first 4,000 which is one-fifth of your 20,000 and then the other options would vest such that you get a specific amount each month for the rest of the vesting period.
Going by our example, 16,000 options would vest at a rate of 1/48 for the remainder 48 months which implies approximately 333 options vested every month.
In conclusion, it is necessary to understand every aspect of your ESO. This way, you are able to make the best decisions.