What Are Employee Stock Options & How Do They Work?

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.

What kind of liquidity events create opportunities to sell stock options?

If you work for a successful startup company, you may experience one of the following liquidity events:

• Initial public offering, or IPO.

  IPOs provide liquidity for the company, give both founders and investors an exit strategy, and offer employees the opportunity to sell stock. Note that some or all employee shares are usually “locked up” for a period of time following an IPO—meaning there’s a waiting period before you can sell them.

• Tender offer.

  This is an event in which investors invite shareholders to sell their shares. The investors set a price that they’re willing to pay, usually at or above the company’s current valuation or stock price. Tender offers are open for a specified period of time—for example, 30 days. They may allow shareholders to sell all of their holdings, or only a certain percentage.

• Acquisition.

  There are three types of acquisitions: all-cash deals, in which all shares and options are bought out in cash; all-stock deals, in which shares and options are converted to shares of the acquiring company; and blended deals, in which shares and options are purchased with a combination of converted equity and cash.

• Secondary market or private sale.

  The secondary market is a marketplace for private investors to buy shares of privately held companies. These deals are usually brokered through an individual or a platform. There’s no guarantee that you’ll be able to sell shares on the secondary market—that depends on investor interest.

How to exercise stock options

Exercising stock options means purchasing shares of a company’s stock at the price set by the issuer or as outlined in your option contract. If you decide to exercise, you’ll officially own a small piece of the company. However, exercising stock options is not a requirement, so you’re not obligated to buy the stock.

If you leave the company (by choice or not), your employer may grant you a post-termination exercise period. This is a window of time in which you can buy shares at the price outlined in your options contract. Most companies give employees 90 days to exercise their vested stock options. If you’re unable to pay for your options, you may be forced to give up your equity.

4 ways to exercise your stock options

If you decide to exercise your options and have met the vesting requirements, there are various strategies you can use to maximize your gains. Be aware that taxes can get complicated, so it’s wise to consult a tax adviser to ensure you’re working toward your financial goals.

1. Exercise and hold.

   If you exercise ISOs and hold them, you can defer your tax obligation until you decide to sell. If you hold for more than a year, you get favorable taxation, because you’ll qualify for long-term capital gains. If you exercise and hold NSOs, you still have to pay income tax on the gain in value you received at the time of exercise. (This is the difference between the strike price and the fair market value at the time of exercise.)

2. Exercise and sell to cover.

   If the company you work for is public or offers a tender offer, you may be able to exercise your options and sell enough shares to cover the purchase price, taxes, and other fees. The rest of your holdings are profit.

3. Exercise and sell.

   You may exercise and sell your options in a single transaction if your company is public or offers a tender offer.

4. Hold.

   If you think the stock price will increase over time, you’re allowed to hold onto it up until the expiration date. Just remember, stock options are worthless once they’ve expired.

What are the benefits and risks of employee stock options?

While stock options can provide employees with potential additional income, there are risks involved.

Benefits

• Lower upfront financial commitment.

  Compared to trading securities on the public market, employee options are usually more cost-effective. Instead of paying the market price, options investors pay the strike price set by their employer.

• Ownership.

  Options give employees the opportunity to have a real stake in the company they work for, which may make some people feel more invested in their company or job.

• Flexibility.

  With options, investors have the ability to make a number of strategic moves, including exercise and hold, exercise and sell to cover, exercise and sell, or hold.

Risks

• Limited time to invest.

  Employee stock options come with an expiration date, leaving investors to decide when to exercise, sell, or walk away before the expiration date.

• Value.

  Determining the value of stock options can be difficult because the grantor (or employer) estimates the value.    

• Tax implications.

  Exercising options may create additional tax burdens.

The bottom line

Stock options can create opportunities for wealth-building beyond your paycheck. But before you sign an employment agreement that includes equity compensation, make sure you have confidence in the company’s long-term potential, you're comfortable with the time commitment required by the vesting schedule, and that you understand what happens to your options when you leave the company. When you’ve vested and you’re ready to exercise, consider the tax ramifications. ‍