Employee stock options (ESOs) have become a widely used employee benefit, especially among startups and tech companies aiming to attract and retain top talent. At its core, an ESO an agreement that gives employees the right to purchase company stock at a predetermined price, allowing you to benefit from the company’s growth if its stock value increases over time.
But, how exactly do employee stock options work? Are there tax implications? And are stock options a good benefit? This guide offers answers to all of these questions and more.
What are employee stock options?
Employee stock options are a form of compensation that gives employees the right to purchase company shares at a fixed price, known as the “exercise price” or “strike price.” This price is typically set lower than the market value the stock might reach in the future, creating an opportunity for employees to profit if the company's stock price rises. ESOs are often used as a way to reward and retain employees while aligning their interests with the company's long-term success.
How do employee stock options work?
To fully understand how ESOs work, it helps to break them down into four key stages that make up their lifecycle:
1. Grant
This is the initial stage when the company offers stock options as part of its compensation package. The grant specifies the number of options you will receive, the exercise price, and the plan terms. For instance, as an employee, you might be granted 1000 options with an exercise price of $10 per share.
2. Vesting
Stock options don’t usually become available for immediate use. Instead, companies set up a vesting schedule, which outlines when employees gain the right to purchase their options. Common vesting schedules include:
- Cliff vesting: Employees must wait a set period (e.g., one year) before all or a portion of the options vest at once.
- Graded vesting: Options vest gradually over time, such as 25% annually over four years.
For example, if an employee has 1000 options with a four-year graded vesting schedule, that means 250 options will vest each year for four years.
3. Exercise
Once vested, employees can purchase their shares by paying the exercise price. If the stock’s current market price is higher than the exercise price, employees can buy the shares at a discount and potentially sell them for a profit later. However, exercising options usually requires upfront cash to cover the cost of the shares and might also trigger tax implications, which we’ll cover later.
4. Selling
After exercising, employees own the shares and can decide when to sell them. Timing is critical, because selling when the stock price is high can maximize gains. However, employees frequently face restrictions, such as “lock-up periods,” during which they can’t sell their shares (typically immediately after purchasing them).
Types of employee stock options
The two main types of employee stock options are incentive stock options (ISOs) and non-qualified stock options (NSOs). They differ in a few key ways.
Incentive stock options (ISOs)
Incentive stock options are generally restricted to employees of the company granting the options. Contractors and outside advisors aren’t eligible to receive ISOs. Exercising the options does not immediately trigger regular income tax. The Internal Revenue Service (IRS) classifies gains from these options as long-term capital gains.
Non-qualified employee stock options (NSOs)
Non-qualified stock options are a more flexible type of employee stock option, with fewer restrictions than ISOs. NSOs are available not only to employees but also to contractors, advisors, and other non-employee service providers, making them more versatile in terms of who can receive them. Profits from these are treated as ordinary income and taxed accordingly.
Employee stock options vs RSUs (restricted stock units)
Restricted stock units (RSUs) are company shares granted to employees as part of their compensation, but they don’t require employees to buy them. Instead, employees earn the shares after a vesting period, which means they have to stay with the company for a certain amount of time before they can own the stock. Once the RSUs vest, employees simply receive the stock, and they can choose to sell it right away or hold onto it for potential future growth.
The main difference between RSUs and employee stock options is that with RSUs, employees don’t need to buy the stock—they’re granted it outright. With ESOs, employees can buy company stock at a set price, which may or may not be beneficial depending on the company’s stock performance. So, while RSUs are easier and less risky for employees, ESOs have the potential for larger gains if the stock price increases significantly.
Are stock options a good benefit?
Employee stock options offer a unique opportunity for financial growth. By giving employees the right to purchase stock at a set price, companies allow them to benefit from any potential increase in the organization’s stock value over time. This means that if the company does well and the stock price rises, employees who bought the stock at a lower price can sell it for a profit.
Another perk is the sense of ownership it provides. Employees who hold stock in the company may feel a greater sense of pride and responsibility, knowing they have a personal stake in the business's success. This ownership can motivate them to be more productive and engaged, as they see a direct connection between their efforts and the company’s growth.
Plus, stock options serve as a tangible recognition of the value of their contributions, helping employees understand how their hard work is reflected in the company's overall performance.
The potential downsides of employee stock options
Employee stock options can be a valuable part of an employee’s compensation package, but they also have risks and complexities that should be carefully considered before committing to them.
Risk of stock price declining
One of the major risks of holding stock options is the possibility that the stock price could decline after the options are granted. Since stock options are tied to the company’s performance, they inherently come with market risks that can affect their value.
If the stock price falls below the exercise price, the options may become “underwater,” meaning they have no immediate financial value. This could lead to employees losing out on the potential gains they were hoping for when they initially received the options.
Tax complexities and obligations
Taxation on stock options is often complicated. “While having stock options is a great thing, they do produce a lot of complexity and should be looked at with an eye toward your personal financial plan,” says certified financial planner Eric Franklin, managing principal and co-founder at Prospero Wealth. Depending on the type of stock options, the tax treatment can vary, and the timing of when the options are exercised and sold can further impact an employee’s tax obligations.
For example, if you receive incentive stock options, you typically won’t owe taxes when they’re granted or exercised. However, if you hold the shares for at least one year after exercising them and two years after receiving the grant, any gains may be taxed at the lower long-term capital gains rate. If you sell earlier, your profits could be taxed as ordinary income, which may be at a higher rate.
Franklin advises employees to consider these tax implications, alongside cash flow needs, and concentration risk—particularly if you already own a significant amount of employer stock. Working with a financial advisor can help you navigate these complexities and plan accordingly.
Limited liquidity, especially in private companies
For employees working in private companies, liquidity can be a major challenge. Stock options can’t always be easily sold in private markets, meaning employees might be stuck holding onto the stock with no immediate way to cash out. If the company doesn’t go public or get acquired, the employee may never be able to realize any gains from their stock options. This lack of liquidity can make it difficult for employees to assess the true value of their options or to access cash for life events like buying a house or paying for education.
Psychological pressure to stay with the company
“Employees must generally remain with the employer to ‘vest’ in the stock options,” says certified financial planner Jim Weil, managing partner at wealth management company Private Vista. “Vesting often requires remaining with the employer for four or five years.”
This can create a sense of obligation to stay at the company, even if the employee feels they’re no longer a good fit for the job or the company culture. This “golden handcuffs” effect can trap employees in roles they might otherwise want to leave, simply because they don’t want to lose the value of their unvested stock options.
Tax implications of employee stock options
Understanding the taxation of employee stock options is crucial for your financial success. The way taxes apply can vary depending on the type of stock option you have and how you manage them through different stages: grant, exercise, and sale.
How taxes apply to NSOs and ISOs at grant, exercise, and sale
At the time of grant, there are generally no immediate tax consequences for either NSOs or ISOs. The main tax action happens when you exercise your options and later sell the stock.
With NSOs, you’ll owe taxes based on the difference between the exercise price and the fair market value of the stock at that time (this is considered ordinary income).
With ISOs, when you exercise the options, you don’t have to pay regular income tax on them right away. However, you might face something called the Alternative Minimum Tax (AMT).
Alternative Minimum Tax (AMT) for ISOs
While ISOs offer tax advantages, they come with the potential trap of AMT. “When you exercise ISOs, the difference between the exercise price and the market price on the exercise date is considered a preference item for AMT purposes,” Franklin says. This means you could owe AMT on this “paper gain” even if you haven’t sold the stock yet.
If the stock price drops significantly after you exercise, this can create a problem. You might have to pay the AMT on the value of the stock when you exercised the options, even though the stock is now worth less. “There are no automatic AMT refunds,” Franklin says. “You may be eligible for a non-refundable AMT credit in future years, but only when your regular tax exceeds your tentative AMT.”
The AMT issue can come as a shock. “ISOs do not trigger regular income tax at exercise, but they may trigger AMT and we have seen this catch employees by surprise,” Weil says.
For example, someone could exercise their ISOs, hold onto the stock, and watch the stock price fall. Despite the decline, they would still have to pay income tax on the value of the stock when they exercised the options, which could be much higher than the stock’s current worth. Without proper planning, this can create a situation where you owe taxes but don’t have the cash to pay for them unless you sell the stock at a loss.
Special considerations for private companies
If you’re working for a private company, there are additional considerations. In private companies, the stock isn’t traded on public markets, so it can be more difficult to sell your shares. This lack of liquidity means you might face tax obligations for a stock you can’t easily sell. This is where it gets tricky: You could exercise the stock options, and owe taxes, but have no immediate way to liquidate the stock to cover those costs.
Key tips for managing employee stock options
Managing your ESOs requires careful thought and planning. Here are the key considerations to help you navigate the process wisely.
Know when to exercise
Deciding when to exercise employee stock options is one of the most important decisions you’ll make, as several factors come into play. Ideally, you want to exercise your options when the stock price is higher than the exercise price, but you also need to weigh the potential tax implications.
Carefully review the employee stock option plan before accepting it. This includes looking for red flags, such as ambiguity about the type of options, vesting schedules, or any hidden fees. Being clear on these aspects ensures you’re making an informed decision about exercising your options at the right time.
Avoiding overreliance on company stock
While stock options can be a powerful wealth-building tool, overreliance on your company’s stock can be risky, especially if the company faces a downturn or you hold a large portion of your wealth in a single asset.
Diversifying allows you to better manage risk and optimize returns over time. Make sure to evaluate your broader investment strategy alongside your stock options to ensure you’re not overly concentrated in one place.
Learn the valuation of private company shares
For employees of private companies, assessing the value of your stock options can be more difficult. Private companies don’t have a publicly traded stock price, which means there’s no clear market value for the shares. To make a better decision, you should understand the company’s valuation and your percentage ownership.
While start-ups often keep the cap table (a list of shareholders) private, they should be willing to help you understand the potential future value of your shares. “You should be able to understand what a happy path to public markets could look like for your shares,” Franklin says.
Consult a tax professional
Given the complexities and risks involved, it’s best to consult with a tax professional who can help you evaluate whether it’s better to exercise your options early, wait, or even sell the stock after it vests to minimize your tax burden. Having a proactive strategy based on solid data—like using a Value at Risk (VaR) ratio and Insight ratio—can make a significant difference in the financial outcomes, potentially saving you thousands or even millions of dollars.
Exercise your options
Employee stock options offer both significant opportunities and risks. On the one hand, they provide employees with the potential for financial growth, aligning their success with the company's performance, and offering retention incentives through vesting schedules. On the other hand, they come with risks, including fluctuations in stock prices, complex tax implications, and potential liquidity challenges, especially in private companies.
However, when managed strategically, ESOs can be a powerful tool for building wealth. Careful planning, including understanding the vesting schedule, considering tax implications, and maintaining a diversified portfolio, can help employees navigate these complexities and maximize their potential rewards. By staying informed and working closely with financial and tax professionals, employees can make their stock options a key part of their financial future.
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