Guide to Stock Options

7 min read

A simple guide to the commonly offered form of compensation by businesses, stock options. Learn about the various types, rules and tax implications.

Guide to Stock Options

Stock options are a common form of compensation that companies provide to incentivize employees to work towards the common goal of growing a company. They act as a form of equity in the company and have the possibility of being worth multiples in the future. While stock options are a great hook to capture job seeker interest, they have their pros and cons, and tax implications that most are not aware of at the time of purchase. In this guide I will break the stock option process down into a simple and consumable manner so anyone can navigate stock options with ease.

Stock Option Offer

Definitions

  • Stock Options - A form of compensation that grants the employees the right to buy a fixed number of shares in a company at a fixed price.
  • Vesting - The employees right to a form of compensation in the present or future.
  • Vesting Schedule - Period of time in which granted stock options will vest.
  • Exercise - The purchase of vested stock options.
  • Refresh Grants - Additional stock options that are granted to an employee after the initial stock option grants.
  • Strike Price - Price of an option at the time the option is exercised.

Every conversation about stock options starts with a formal offer from a company looking to hire you. If you are being offered stock options, then your offer letter will make reference to the stock option shares being offered, the classification of those shares, and their vesting schedule. In the following sections I will provide more detail on what all of this means, but before moving on, here are a few questions to think about and ask your employer in regard to the stock options being offered:

  1. What does this stock option amount represent in relation to the company valuation?
  2. What is the framework that the company uses to decide on granting stock options?
  3. How long after leaving the company will I have to exercise my options?
  4. What type of liquidity do these shares have?
  5. Do you offer “refresh grants”?

Types of Stock Options

There are three common types of stock options that have their own rules and unique tax structures. It is important that you understand their nuances as it can dramatically impact the outcome of the value of the sale of your shares.

Restricted Stock Units (RSUs)

Restricted Stock Units are a type of option that has special leverage and taxation that other stock options do not offer. To start, while they are considered to be a part of the family of stock options, this is actually a company’s promise to give you shares of its stock or the cash equivalent to the stocks value. They follow a vesting schedule like the other compensation types mentioned, but the main difference is that you own the shares at vesting, rather than having the option to exercise those shares at any given date. Similarly, you pay the tax on those vested shares at the time of vesting, whereas those who have the flexibility to take or leave an option can pay at the time of exercising or a future date. In addition, these shares can carry special voting and dividend rights depending on the company policy that retain value regardless of share price decrease. None of these attributes are associated with ISOs and NSOs.

Incentive Stock Options (ISOs)

Incentive Stock Options are the most common stock option offered to employees who aren’t founding or executive members. This option is different from an RSU as it does not have the same special privileges and shares are not given to you at the time of vesting. ISOs must be purchased by the person who has been granted the options and at a strike price that is based on the shares fair market value. ISOs adhere to an Internal Revenue Code (IRC) restricting the options to only employees of a company and rules must be followed pertaining to the amount that can be exercised and owned (For more see IRC - Code 422). ISOs follow a vesting schedule that decides the options that are granted to an individual to exercise at a given time. The decision to exercise and purchase those options are left to the individual and when exercised are not immediately taxed unless the options are sold directly after exercising (see Stock Option Taxes for more detail).

Non-Qualified Stock Options (NSOs)

This is a simple stock option that differs from the previous options as it does not have special privileges like an RSU, has a different tax structure than both and has flexibility around who can be offered the stock option since it does not adhere to the regulatory standards like ISOs. NSO’s can be offered to employees, as well as outside service providers, contractors and consultants. These options are offered at a preset price that typically aligns with the market value of the shares at the time of the option grant.


Exercising Stock Options

Definitions

  • Vesting Cliff - When a specific amount of options vest at a specific date rather than gradually over a period of time.

Restricted Stock Units (RSUs)

There is no exercising option like ISOs and NSOs as you own the shares outright if certain restrictions (typically performance oriented) the company outlines are met by the grant date. The company will give you the shares or a cash equivalent for free rather than require you to purchase the shares.

Incentive Stock Options (ISOs) & Non-Qualified Stock Options (NSOs)

ISOs give you the ability to exercise a percentage of stock options based on a vesting schedule. Traditional vesting schedules last four years from the initial grant date. Shares typically vest based on the percentage of time elapsed from the date the options are granted to the end of the vesting schedule with the only exception being a vesting cliff in the first year of vesting. This cliff is traditionally 25% of your shares which will not vest until the completion of your first year with the company. This means that if you leave at any point before your first work anniversary, then you will not have any options to exercise. After this cliff, shares typically vest daily until the completion of the schedule. Consult with your company to know if they follow the traditional vesting schedule described above.

Leaving Your Company or Termination

In the event that you leave the company, you will have a limited amount of time after leaving to exercise the options that have vested. Companies typically provide you with anywhere from 90 days to up to a year from the day of employment termination to exercise the options. This date is specific to your company policy so check with your company to know the exact amount of time you have.


Stock Option Taxes

Definitions

  • Ordinary Income Tax - Any type of income taxed at marginal tax rates. This type of tax is commonly associated with wages, salaries and commissions.
  • Capital Gains Tax - Tax for any profit above the price of the stock when you originally exercised.
  • Alternative Minimum Tax - Income tax that is applied to certain taxpayers to ensure a minimum tax is paid. This tax has its own set of rules that eliminates a lot of the standard deductions that one might apply to reduce tax owed. High earners are typically the taxpayers who are impacted by this tax.
  • Fair Market Value - Price that the option would sell for on the open market.

Restricted Stock Units (RSUs)

Your company will typically handle the taxes associated with the vested units by withholding tax automatically on the RSUs on your paycheck, but it would be good to check with your employer before you are hit with unforeseen taxes by the government.


Incentive Stock Options (ISOs)

Your tax situation will be different depending on what you do with the options at the time of exercising.


If you sell your exercised options right away:

You will lose the tax advantage that ISOs have over NSOs and will have to pay taxes as if the options were an NSO. This means you will pay the ordinary income tax on the difference between the strike price and the fair market value at the time of the sale. This tax is traditionally higher than the tax paid for capital gains.


If you hold your exercised options for at least a year after the exercise date and at least two years after the grant date:

Your shares will be eligible for a tax benefit by paying a capital gains tax rather than ordinary income tax. However, you may be subject to alternative minimum tax (AMT) depending on the type of earner that you are. This is important to note because if you qualify for the AMT your tax situation will be much different than if you were to pay capital gains tax (see Alternative Minimum Tax for more detail).


Non-Qualified Stock Options (NSOs)

You must pay the ordinary income tax at the time of exercising the options. This tax occurs when there is a difference between the strike price and the fair market value at the time of the sale.


If you sell immediately:

This will be the only tax that you will pay.

If you sell in less than a year after exercising:

You will additionally pay a short-term capital gains tax on any increase since exercising.

If you sell more than a year after exercising:

You will additionally pay a long-term capital gains tax on any increase since exercising. Long-term capital gains tax rates tend to be lower than short-term rates.

Alternative Minimum Tax (AMT)

The alternative minimum tax (AMT) was put in place to make sure all taxpayers were paying an appropriate amount of income tax relative to their tax profile. If you make more than the AMT exemption amount, then you will pay taxes on the higher of the two tax types, ordinary income tax and AMT. This is important to note for ISO holders because it can impact the spread between the purchase and the grant price that is subject to the AMT. For further information on AMT and how it might relate to your tax situation, please refer to this NCEO article on the topic.


Stock Option Criticism

While stock options are pitched to employees as a form of ownership, not everyone views it this way and some have even shared their criticism based on personal experiences. Shared below are some articles and tweets that I have come across exposing the issues with stock options.


What I Wish I'd Known About Equity Before Joining A Unicorn - A great writeup focusing on the issues of stock options. It is very opinionated and mostly criticizes the way “unicorn” startups promote stock options to its employees, but I believe there are valid points made about the value of a stock option.

“Stock Options are a Lie” - Retweet Quote from Chamath Palihapitiya (VC and CEO Social Capital) regarding a tweet from Basecamp CEO Jason Fried arguing that equity is not ownership if it represents 1% of the company equity.

Former Uber employees have gone into debt to hang onto shares they still can’t sell - The reality of those dreaming of a pay day from stock options at a “unicorn” startup.

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