An Employee Stock Options Guide

Ken Hargreaves

What is an employee stock option?

An employee stock option(ESO) is a contract that a corporation (granter) issues to an employee (grantee) that gives them the right to purchase a set amount of shares at a predetermined price (known as the strike price) within a specific time window. The employee can exercise the contract whenever they see fit within that time window, thereby triggering a purchase of the underlying security at the agreed-upon price, regardless of the current market price.
The employee (grantee) then turns around and sells the shares at market price. The profit is the difference in price between the option contract’s price and the market’s current price of the underlying asset – after subtracting fees, taxes, and bid/ask spreads.
For example: Company XYZ gives James 100 stock options. The options allow James to purchase the shares for $10 each. When the company provided James with the options, the share price was $9. It doesn’t make sense for James to exercise those options and purchase them at $10 a share if they are only worth $9.
So James waits until the shares are worth $20. He exercises the options, purchases 100 shares at $10 each, and instantly sells them for $20 each for a profit of around $1,000.

When Should James Exercise?

If Company XYZ issues James his options in 2019, we can see from the above graph that it only becomes profitable to exercise them at some point after 2020. If James exercises them when shares are worth $20, he stands to profit $1,000. If he waits, he could even make more. But, they expire in 2023, so he has to make a decision before then. He even runs the risk of them going back down in price.

Strike Price and Expiration Date

Options have an expiration date, meaning you must exercise them before that date. If you don’t, they expire worthless, even if they are “in the money.” It’s doubtful an employee would allow their options (their incentive bonus) to expire if they are in the money, but there is a very real risk of the options expiring worthless by never rising above the strike price – or diving down below the strike price and remaining there, as shown in the two examples above. As we can see in Chart B, James should have exercised in 2022, but decided to hold until the last minute, with unfortunate results.

Why do companies issue Employee Stock Options?

The ESOs (employee stock options) serve as an incentive for James to work extra hard. It puts the amount of his bonus into his own hands, with the sky as the limit. The logic is as follows – the more diligently James and his fellow employees with stock options work, the greater the chance the stock will rise above the strike price.
In theory, the stock price could rise to $1,000 – or $10,000, making any option owners very wealthy, which is one reason why ESOs are very popular amongst startups and tech companies. Many of us have heard rags-to-riches stories due to ESOs. One famous example is Facebook graffiti artist David Chloe, who ended up with $200,000,000(!) of stock options when Facebook went public.
James’ scenario explains a vanilla “call” option, which is bullish in nature (meaning, the hope is that the value of the underlying security will increase – this is in contrast to a bearish “put” option). A company may even reward “in the money” ESOs for achieving a Key Performance Indicator.
But not all ESOs are as simple as James’ situation above. Many companies offer a variety of ESOs with different restrictions and rules. Here’s a quick run-through of the most common ones.

Kinds of Employee Stock Options

Incentive Stock Options

These are the ESOs you hear about when the CEO of XYZ receives a large block of stock options as part of their remuneration package. Companies offer these kinds of ESOs to key employees and executives to retain their talent and incentivize performance. They may also be used as a part of a talent acquisition strategy.
The usual vesting time is two years, after which the grantee must wait one year to sell the stocks received upon exercising the options. Here we see a downside of ISOs. Should the stock drop below the strike price, the grantee can end up losing money. It should also be noted that the grantee MUST exercise their ISOs within ten years.
Incentive Stock Options are tax-advantaged, meaning that recipients of these options only have to pay relatively low capital gains taxes as opposed to regular income taxes, which are much higher. The grantee must hold the stocks for one year to qualify for capital gains tax.

Non-qualified Stock Options

These are for all other employees, board members, and consultants. They do not possess the tax advantages of Incentive Stock Options. Similar to ISOs, they may also come with caveats, such as vesting, limiting the grantee’s ability to exercise the option.
Non-qualified stock options are particularly popular with young companies that don’t have the funds to pay large salaries, so instead, they offer ESOs to make up for it. Unlike an ISO, the bearer of the options is not constrained by a holding period. This means that, after any existing vesting period, the grantee can exercise their options without further delay.

Employee Stock Option Alternatives

There are other ways to tie performance and loyalty to a company’s stock without utilizing ESOs. Some examples are Restricted Stock Units (RSUs), Phantom Stock, and Employee Stock Purchasing Plans. Stay tuned for an article explaining how they differentiate from standard Employee Stock Options.

Employee Stock Option Plans in Labor Contracts

When you start a new job, all ESOs they will grant you must be clearly stated, including the precise conditions attached to the ESOs. Conditions include strike prices (often the current price of the shares if already publicly traded), vesting periods, holding times, and exercise methods. The question of when to exercise your options and how the government will tax them is beyond the scope of this article today, but stay tuned for individual pieces on those exact subjects.

Employee Stock Option Vesting Schedules

The vesting schedule of an employee stock option plan states how many options per year an employee will get. For example, James has a five-year contract with Company XYZ. In this contract, XYZ states he will receive 400 ESOs by the end of the 5th year of his employment.
In his second year working there, he gets 100 stock options, meaning he is 25% vested. If they are non-qualified options, he can exercise them straight away if they are in the money – alternatively, he can hope the stock price will go up and hold them. The following year, he gets another 100 options. This process continues for another four years, after which he will be 100% vested.
The vesting schedule can also be connected with Key Performance Indicators. These are referred to as Performance Stock Options. The company will reward James if the Total Return on Capital is over $10,000,000 – as an example. James does well for himself when the company prospers and misses out on bonuses when business is lousy. It would behoove James and any other grantees of Performance Stock Options to work hard to improve the bottom line.

In Conclusion

Employee Stock Options are a great tool to retain and attract top talent. They also incentivize employees to perform effectively, as it is in their best interest for a company to grow and thrive.
Has your company issued you ESOs? Make an appointment today to better understand your tax obligations, how they fit into your overall investment portfolio, and the optimal time to exercise them.
Disclosures

Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s portfolio. All investment strategies have the potential for profit or loss. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author/presenter as of the date of publication and are subject to change and do not constitute personalized investment advice. 

A professional advisor should be consulted before implementing any investment strategy. WealthGen Advisors does not represent, warranty, or imply that the services or methods of analysis employed by the Firm can or will predict future results, successfully identify market tops or bottoms, or insulate clients from losses due to market corrections or declines. Investments are subject to market risks and potential loss of principal invested, and all investment strategies likewise have the potential for profit or loss. Past performance is no guarantee of future results. 

Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s portfolio. There are also no assurances that any portfolio will match or outperform any particular benchmark. No content should be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell any securities mentioned herein.

  • Ken Hargreaves

    A Florida native, and full-time Sarasota resident, Ken founded WealthGen Advisors, LLC after spending more than fourteen years in the financial advisory industry. Prior to founding WealthGen Advisors, Ken spent almost a decade in New York and then Texas as Vice President at The Capital Group, a $2T global investment manager serving institutional clients and pension funds.

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