What are Stock Options?

By: AJ Ayers, CFP®

You might be wondering, "Why should I even bother understanding stock options?"

Well, some of the biggest names in the tech industry offer stock-based compensation as a significant part of their total compensation package.

For example:

Snap: 54%

Lyft: 53%

Airbnb: 51%

Instacart: 44%

These numbers are not just random figures; they signify a trend in how companies are incentivising their employees and executives. If you're not in the loop, you could be missing out on a substantial part of your potential earnings.

Are you ready to unlock the potential of stock options and possibly transform your financial future? Let's dive in.

What Is a Stock Option?

A stock option is a financial instrument that grants the holder the right to buy or sell a stock at a predetermined price within a certain period, or on a specific date. If you google “stock options” you’ll likely get a bunch of articles about trading options and options strategies. There are two main types of stock options: call options and put options. But that’s not what we’re talking about here today. We’re talking about stock options typically granted to employees at privately held companies. If you’re looking for more information about options trading in public markets we suggest you think long and hard about your tolerance for this incredibly risky business.

So let’s focus on the private markets. Companies often use stock options as part of their stock option plans to attract, retain, and incentivize talented employees. In such plans, employees are granted stock options that vest over a certain period, enabling them to buy a set number of shares of the company's stock at a predetermined price. This can be a lucrative form of compensation, as employees stand to benefit from any increase in the company's stock price, aligning their interests with those of the shareholders.

What Are Employee Stock Options?

Employee stock options are a form of equity compensation that companies use to attract, retain, and motivate their workforce. They give employees the right, but not the obligation, to buy company shares at a predetermined price. This is known as the exercise price, which is available to employees for a specific period.

There are two primary types of employee equity compensation: The employee stock option plan (ESOP), and the employee stock purchase plan (ESPP). ESOPs allow employees to buy a set number of shares at a fixed price, while ESPPs allow employees to purchase company stock, usually at a discounted price, through payroll deductions.

When considering how stock options work, it's essential to understand that they only become valuable if the company's stock price increases, allowing employees to buy shares at a lower price than the market value. This potential upside is why employee stock options are an attractive form of equity compensation for employees and employers.

Once granted, employees typically have a waiting period, the "vesting period," before they can exercise their stock options. The vesting period ensures that employees stay committed to the company and contribute to its growth while they wait to benefit from the stock increase.

After the vesting period, employees have a specific time to exercise their options. Exercising a stock option means that an employee decides to buy the company shares at the agreed-upon exercise price. If they choose not to exercise their options before the expiration date, they forfeit the right to purchase the shares, and the options expire worthless.

Types of Stock Options

For the sophisticated professional seeking clarity on the different options, we've outlined two main stock options you'll likely come across: incentive stock options (ISOs) and non-qualified stock options (NQOs).

Incentive Stock Options (ISOs) are a form of employee stock option plan that provides tax advantages. Specifically, employees are not required to pay ordinary income tax on the difference between the grant and exercise prices when they use their options. However, the potential downside is that employees might be subject to alternative minimum tax (AMT) in some situations. This stock option is generally found in the United States and can only be granted to employees.

Non-Qualified Stock Options (NQOs) differ from ISOs because they do not offer any preferred tax treatment for employees. Upon exercising the option, employees must pay ordinary income tax on the difference between the grant and exercise prices, regardless of whether they sell the stock immediately or hold onto it. NQOs are available to anyone, including employees, contractors, and non-employees.

In addition to these main types of stock options, professionals should be aware of Restricted Stock Units (RSUs). RSUs are not stock options but a form of compensation granted by an employer in the form of company stock. RSUs do not require the employee to pay for the stock shares. Instead, the company provides a certain number of shares that become fully vested over time; meaning they can provide a steady income stream for employees as the RSUs vest.

When it comes to developing a comprehensive options strategy, it's essential to consider the various types of options available. As you explore the world of stock options, incentive stock, and other employee stock options, remember to prioritize optimizing your financial goals with a trusted technical expert. With the proper guidance and strategy, the world of stock options can be one of the most efficient ways to grow your wealth.

Considerations When Dealing With Stock Options

When contemplating stock options, it's essential to understand factors that could impact their value and the decisions involved in managing them. Primary considerations include tax implications, strike price, stock price, market value, and the employee's relationship with the company.

A crucial element to consider is the tax consequences of stock options. For example, exercising stock options, selling company stock, and purchasing stock can all have varying tax effects. It's essential to consult with a knowledgeable professional to understand the specific tax implications for your situation.

Stock options get their value from the difference between a company's stock's strike price and the market price. The strike price is the fixed price at which you can buy or sell the underlying stock, while the market price is what the stock is currently trading at. To make a profit when you exercise your options, the market price must be higher than the strike price.

Making decisions about when to buy the underlying stock, sell it, or hold it can depend on various factors. For instance, the company's performance, expected growth, and stock market trends are significant in determining whether buying or selling a stock is in your best interest. In some cases, waiting for the stock price to increase might be worthwhile before exercising your options.

It's also crucial to consider how your stock options might be affected if you leave the company. In most cases, employees have a specific time frame—usually 90 days—when they must exercise their options after departing the company. If you don't purchase your options within that period, they will expire, and you lose the opportunity to cash in on them.

Finally, when dealing with stock options, always stay informed and make decisions based on logic and objective criteria rather than emotions or personal biases. Focus on being an optimizer, making choices that align with your financial goals, and understanding when it's best to take action, whether exercising, selling, or holding onto your options.

How Do Employee Stock Options Work?

Imagine you work at a startup and are awarded 100 stock options as part of your compensation package. Each option allows you to buy one share of the stock at a strike price of $20. Here's the twist: The options vest over four years, which means that every year, you'll be granted the right to exercise 25 of the 100 options.

After three years, the stock's price has risen to $40 per share. You can now exercise 75 of your stock options and buy 75 shares at the original strike price of $20 per share. In this case, you'll be spending $1,500 to buy shares that are now worth $3,000. Quite a deal, right? But, you also have the option to keep the options unexercised until the end of year four, hoping for an even higher stock price.

Stock options can be an attractive way for companies to incentivize employees, and align the interests of employees and shareholders. As an employee, these options mean you'll be motivated to help the startup succeed and increase its stock price to benefit your wealth.

However, it's essential to understand that stock options come with risks. For example, if the stock's price dropped below the strike price, the options would be considered "underwater" and lose value. This could decrease the overall compensation of an employee who relies heavily on stock options.

Frequently Asked Questions

How do stock options differ from shares?

Stock options are different from actual shares of a company's stock. When an employee is granted stock options, it gives them the right to purchase a specific number of shares at a fixed price, known as the strike price, within a particular time frame. On the other hand, shares are units of ownership in a company and are purchased directly by investors or employees at their current market price.

What perks do employees get from stock options?

Stock options can offer several benefits for employees. First, they provide a financial incentive as the employee stands to gain if the company's stock price increases over time. Stock options can also instill a sense of ownership and promote employee loyalty by aligning their interests with the company's success. Additionally, they can serve as a valuable tool for companies in attracting and retaining top talent. A study showed that most workers report that cash incentives, stock options, and ESOP stock motivate them to work harder.

What's the difference between stock options and RSUs?

Both stock options and Restricted Stock Units (RSUs) can be used as employee compensation tools, but they have different characteristics. While stock options give employees the right to purchase shares at a specific price (strike price) within a specified time, RSUs are essentially grants of company stock that given to employees at no cost. RSUs are usually subject to a vesting schedule and become actual shares once vested, unlike stock options that require the option holder to exercise the option and purchase shares at the strike price.

How do stock options work in startups?

In startups, stock options are a common way to attract and retain key employees. Startups typically have limited resources when trying to scale a business, so offering equity compensation can be an appealing alternative to high salaries. Startups can attract higher level talent with the potential of future financial gain while being able to keep salary expenses low in the short term. When an employee receives stock options in a startup, they have the potential to buy company shares at a future date, typically after a vesting period, at a predetermined strike price. If the startup is successful and its stock price increases, the employee can earn a substantial return on their investment by exercising their options and selling their shares at the higher market price.