Employee stock options are an important way that companies compensate workers, especially among startups. They also are a way for early-stage investors to buy into a company before it’s publicly traded, often at a discount.
Options do double or triple duty for employers: They encourage potential workers to join the company, provide some non-cash compensation that can offset below-market salaries, and compel employees to stay with the company for or beyond their vesting period.
Understanding employee stock options
As the name suggests, employee stock options (ESOs) are an option to buy shares of a company at a set price. If you receive stock options, you’re under no obligation to buy them.
Privately held companies typically set their own plans and pricing system, known as a stock-option plan. This document contains the terms and conditions of the options to be granted, including the strike price and any limitations. This is a standard document that’s given to employees who qualify.
A grant of employee stock options gives employees the right to buy a specific number of shares at a set price—that is, the “strike price” or “exercise price”—for a specific period of time, also known as the vesting period.
Employee stock options cannot be exercised—and they can’t be bought and sold—before the vesting period or after the expiration date.
Types of employee stock options
There are two main types of options companies issue to their employees: non-qualified stock options (NSOs) and incentive stock options (ISOs).
Incentive stock options (ISOs)
ISOs, sometimes referred to as “statutory” or “qualified stock options,” are typically only given to full-time employees of a company. By definition, ISO grants are valid for as long as 10 years or three months after an employee leaves a company—whichever happens first. Some companies may convert ISOs to NSOs when employees leave.
ISOs have more favorable taxation than NSOs, because you don’t pay taxes on their value when you exercise—you only pay taxes when you sell. If you sell less than a year after exercise, the profit is treated as ordinary income. If you hold for at least one year after the exercise date and two years after the grant date, the profits are taxed at the lower long-term capital gains rate.
Non-qualified stock options (NSOs)
NSOs, the most common type of employee stock option, can be offered to consultants, contractors, and employees. These options do not have the potential for favorable taxation like ISOs do, but the requirements for their issue are looser.
When you exercise NSOs, you're immediately obligated to pay ordinary income tax on the difference between your strike price and the fair market value of the shares. This means you’ll need enough capital to pay for the shares themselves, plus the tax obligation. This is risky if the company is private and there’s no way to immediately sell some of the shares on a public stock exchange.
How much you pay in taxes is based on how long you held the shares. If you exercise your options and sell the shares within one year of the exercise date, the IRS will ask you to report the transaction as a short-term capital gain. If you sell your shares after one year of your exercise date, it’s considered a long-term capital gain.
How does vesting work?
When an employee is granted stock options, they can’t exercise them right away. Rather, there’s a vesting schedule in which portions of the option vests over time.
The standard vesting period is four years with a one-year cliff. When an employee reaches the cliff, they vest one quarter of their granted shares. After that, they typically vest in monthly increments for the duration of the term.
For example, if your employer grants you 15,000 shares with a four-year vesting schedule and a one-year cliff, you’ll need to stay with the company one full year before you can exercise your first 3,750 shares. After the cliff, 2.1% or 1/48 of the remaining shares vest each month until the vesting period is over. To exercise all 15,000 shares, you’d need to stay with the company for four years.
How to think about the value of stock options
The value of your stock options depends on four variables:
- Strike price
- Fair market value, usually based on the company’s valuation at the time the options are granted
- The remaining life of the option (how long until the expiration date)
- The likelihood of a liquidity event
The higher the fair market value in comparison to the strike price, the greater the value of the option. So, if the strike price is $5 and the fair market value is $30, your options would be worth $25 per share. If math isn’t your strong suit, consider using a stock options calculator to calculate the value of your options.
The other factor to consider when evaluating the value of your options is risk. Paying to exercise stock options without an immediate opportunity to sell them is risky. You may end up investing cash in options whose value never goes beyond numbers on paper.
Certain information contained in here has been obtained from third-party sources. While taken from sources believed to be reliable, Titan has not independently verified such information and makes no representations about the accuracy of the information or its appropriateness for a given situation. In addition, this content may include third-party advertisements; Titan has not reviewed such advertisements and does not endorse any advertising content contained therein.
This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Furthermore, this content is not directed at nor intended for use by any investors or prospective investors, and may not under any circumstances be relied upon when making a decision to invest in any strategy managed by Titan. Any investments referred to, or described are not representative of all investments in strategies managed by Titan, and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results.
Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. Please see Titan’s Legal Page for additional important information.