How Do Stock Options Work?
A stock option is a contract that allows a person to purchase a number of shares of stock at a fixed price, sometimes referred to as an exercise price or a strike price. These contracts are called “options” because the person in possession of a stock option may purchase a share of stock at the specific price associated with the option contract, but they aren’t required to. They could alternatively not purchase the stock and simply let the option expire—and yes, options do come with an expiration date.
So, there you have it: stock options in a nutshell. Of course, there’s a lot more to know about how stock options work, how they’re taxed, and what other forms of equity-based compensation are out there. We’ll cover all of that in this article.
Keep in mind that our focus here will be on employee stock options and not on traders who buy and sell options contracts on the stock market, but some of the same principles and definitions apply to both.
- What are employee stock options?
- What are Incentive Stock Options (ISOs)?
- What are Non-Qualified Stock Options (NSOs)?
- Other important terms and definitions
- How do stock options work?
- How to exercise stock options
- When to exercise stock options
- How are stock options different from RSUs?
- Final thoughts
What are employee stock options?
An employee stock option is a type of compensation that allows, but does not obligate, the employee to purchase a number of shares of company stock at a fixed price. As with any other type of stock option, this price is referred to as the exercise price or the strike price.
Employee stock options are a popular form of equity-based compensation because they ideally represent a good deal for both the employee and the employer:
- The employee doesn’t have to pay taxes at the time their options are granted, and they also get something that will grow in value if the value of the company’s shares grows.
- The employer, for their part, can use the lure of stock options to attract competitive talent and incentivize employees to grow the value of their company well into the future.
Assume the company in question is an early-stage startup with a compelling business and plenty of room to grow in the coming years, and you can see the win-win appeal.
Certain regulations govern how the exercise price for a granted stock option is set. For example, private companies that issue stock options must complete a 409A valuation to determine the value of common shares (and, thus, the strike price of the options). You can read more about that in our guide to 409A valuations, but for now let’s keep the focus on options themselves.
To that end, it’s helpful to start with some key definitions and terms. Let’s first explore two types of stock options you should know about: incentive stock options (ISOs) and non-qualified stock options (NSOs). Then, we’ll look at a few other terms to help you fully wrap your head around how stock options work.
What are incentive stock options (ISOs)?
An incentive stock option, also called an ISO, is a type of stock option that can only be granted to a company’s employees. ISOs may qualify for preferential tax treatment under the U.S. Internal Revenue Code, but to do so they must meet a certain set of criteria.
If these criteria are met, the recipient of the ISO only pays federal income taxes when they sell the stock. This is generally good for the employee, who can exercise his or her options without worrying about the immediate tax implications of doing so.
What are non-qualified stock options (NSOs)?
Sometimes you or your leadership team may want to offer stock options to folks who aren’t, strictly speaking, employees of your company. Non-qualified stock options, or NSOs, allow for this to happen. NSOs may be granted to employees, sure, but they can also be granted to a number of other qualifying service providers—including contractors, consultants, advisors, vendors, and other key players who help a business grow.
So, why not just grant everyone NSOs and not even worry about ISOs at all? Because ISOs have certain tax benefits that NSOs do not. Chiefly: NSOs are taxed at the ordinary federal income tax rate when they’re exercised, while ISOs are only taxed when the employee sells the stock. This tax for NSOs applies to the difference between the exercise price and the fair market value of the common shares at the time the options are exercised.
Other important terms and definitions
- Option grant agreement: An option grant is the agreement between a company and an employee that outlines the grant date, how many stock options the employee will be granted, the strike price on those options, and when those options will vest and/or expire. An option grant should include basically everything the employee needs to understand about how a company will reward them with options, and it’s typically signed at some point after the offer letter (there may be a short delay between the offer letter and the actual grant).
- Strike price: The strike price, also known as the exercise price, is the price at which the underlying security can be bought by the option holder. In other words, your strike price determines what you’ll pay for your shares of the company when you exercise your options–regardless of the current market value of the company stock.
- Market value: Also referred to as the market price of the stock, the “market value” of a stock is the price that the stock would sell for in the open market. (Note: This typically applies only to public companies, as there usually isn’t an open market for shares of private companies.) The current price of a stock is an important consideration to take into account when determining when and whether to exercise your options, as the difference between your strike price and the underlying stock price sets the value for your options.
- Out-of-the-money (OTM): Here’s a bit of trader lingo for you. An option is considered “out-of-the-money” if the strike price is higher than the underlying stock price. In this case, the amount you’d pay to exercise the option is more than you could sell the resulting shares for. Because of this, the option has no intrinsic value—though it may have value in the future if the underlying stock price rises above the stock price before the option’s expiration date.
- In-the-money (ITM): An option is considered “in-the-money” if the strike price is lower than the underlying stock price. In this case, the option has intrinsic value because you can exercise the option and purchase the stock for a strike price that’s less than what you would pay on the open market.
- Vesting schedule: Typically, when an employee is granted options or shares of equity at a company, they don’t get all of it upfront. Instead, the employee earns their options or shares based on a vesting schedule. This vesting schedule may be based on a specific period of time (e.g. four years) or milestone (e.g. a certain business valuation) that’s determined at the time of the grant. Many time-based vesting schedules come with a one-year vesting period or “vesting cliff,” meaning that vesting begins only after the employee has stayed with a company for one year.
- Expiration date: This is the date at which stock options are set to expire. Up until this date, the option holder can choose to exercise their options at the agreed-upon strike price. A stock option retains no value beyond its expiration date, so it’s important to not let this date pass if you intend to exercise your options.
How do stock options work?
In order to fully understand how stock options work, let’s use a real-life (i.e. hypothetical) example involving a software engineer. We’ll call her Laura.
Laura accepts a job at an up-and-coming startup. Along with her job offer, she receives and signs an option grant that says she will get stock options for 40,000 shares of company stock.
Laura’s option grant also details that the strike price for her options is $5. So, if she exercises all of her options at some future date, she will buy 40,000 shares of common stock at a set price of $5 per share, for a grand total of $200,000 (40,000 x $5).
All of this sounds good so far. But Laura will not receive all of her stock options on Day One of her new job, because her options vest over a period of four years with a one-year vesting cliff. After working at her new company for one year, Laura will receive options for 10,000 shares of company stock (1/4th of her total grant). Once she’s past that first cliff, her options will vest on a regular quarterly schedule, so she can expect to receive 1/16th of her total grant every quarter for the next three years, until she has the right to exercise options for all 40,000 shares.
Other factors may impact when and how Laura decides to exercise her options. She may have to consider:
- the expiration date on her options,
- whether her company offers her the ability to early exercise if the company isn’t already public,
- whether her strike price is below the fair market value of the shares (i.e. her options are in the money).
Taxes also play a big role in the decision to exercise options or not. Since everyone’s personal tax situation is unique, it pays to find a good tax accountant and/or financial advisor to help you walk through each possible scenario and figure out which is the best for you.
How to exercise stock options
You may have a number of choices to consider when exercising stock options, which is another fine reason to enlist the services of a tax accountant. Here’s a quick breakdown of some choices you may have once your options are fully vested:
- Hold onto them. Hey, you don’t have to exercise your options right away. You may want to wait a bit longer to pull the trigger if you believe the market price of the company stock is going to go up, up, and away. Just be aware that stock options do have an expiration date, and you will need to make a decision before that date if you don’t want your options to expire with no value. Also keep in mind that sometimes the value of the option itself decreases the longer you hold onto it.
- Pay cash to exercise the options. This option is sometimes called a cash payment, and it’s pretty straightforward: you pay the cash to exercise your options out-of-pocket.
- Sell stock to cover your costs. This one typically applies more to employees at public companies, as it requires there to be a market for the shares. It allows you to sell off a portion of your shares—including the shares you receive from the exercise of the options—to cover the costs you incur (including taxes and brokerage fees) when exercising your stock options. You may have the option to receive the remaining shares of common stock in your account (a “cashless hold”) or to sell off all those remaining shares at the market price and invest the proceeds elsewhere (a “cashless exercise”).
When to exercise stock options
Knowing when to exercise your stock options can be difficult, and there’s no one answer that works for everybody. You’ll need to consider a number of the factors we outlined above, and probably a fair number of other factors that are personal to you.
Taxes can be a major factor in determining when to exercise options, and the tax strategies that save you the most money can also be dizzying in their complexity. That’s why we’ll say it again, even though you may be sick of hearing it: find a good tax accountant. Now is hardly the time to skimp on financial planning.
How are stock options different from RSUs?
Aside from stock options, restricted stock units (RSUs) are probably the most common type of equity-based compensation.
Like stock options, RSUs tend to be earned on a vesting schedule. Unlike stock options, they don’t have a strike price. Instead, they convert into common stock when they vest.
We have a whole guide that outlines the differences between stock options and restricted stock units (RSUs). And believe us, there are some key differences you’ll want to know—including how each type of equity is taxed and which type or stage of company they’re best suited for.
If you’re wondering how stock options work, chances are you’re preparing for (or already in the midst of) a pretty exciting time! Equity compensation can be a thrilling benefit for both founders and employees, and it’s all part of the ride that makes founding a startup a worthwhile endeavor.
Still…we know you still may have some questions about equity and where to go from here. And Pulley is here to help. Schedule time with our cap table experts to get started today.
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