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How Do Stock Options Work?

How Do Stock Options Work?

April 03, 2022
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As you progress in your career, especially if you work in corporate America, one of the first changes you see is in your compensation. Instead of simply getting an increase in pay, corporations often incentivize their employees, and attract new hires, by offering equity - or the opportunity to buy equity - in the corporation. 

To that end, we're kicking off a series walking you through the different types of equity-based compensation and employee benefits.

In Part 1 we started with discussing Restricted Stock Units, or RSUs for short.

In Part 2 we're covering another form of popular equity compensation: Stock Options

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In discussing equity-based pay, we're breaking each form of compensation into one of two types:

  • Will Be Yours: equity in the company that you WILL have if you meet certain conditions

  • Could Be Yours: equity in the company that could be yours if you meet certain conditions AND have the money to pay for it

The Restricted Stock Units we covered in Part 1 are Will Be Yours benefits; as long as you meet the terms required for them to vest, you will get your shares of stock.

Stock Options are a Could Be Yours benefit. A company gives you the option to buy a certain number of shares at a predetermined price, and those shares could be yours IF you have the money to pay for them within a set period of time.

We covered that RSUs are a type of compensation typically typically offered to executives and hew hires at companies that are already public, or private companies that are close to going public. Why? RSUs have immediate value based upon the share price of the company's stock, as the exec or new hire WILL own the shares if they stay at the company long enough to meet the vesting requirements. When an employee's RSU vests, it is the same effect as them receiving a cash bonus, except this benefit comes in the form of company stock.

Conversely, stock options can be offered to employees of all levels at companies who hope to one day go public -even if the date they do so is far in the future, or by public companies hoping to explode in growth. Why? As you'll see in a second, the benefit of stock options to the employee is not just the ability to buy company stock, but the ability to do so at a discount.

Here are some key terms to know regarding stock options, some of which you've already learned in Part 1:

  • Vesting schedule: the terms regarding the length of time one must wait to be able to use their stock option.
    • Example: an executive is granted an option to buy 1,000 shares of company stock over a 4 year period, with 250 options "vesting" each year

  • Grant date: the date an option to buy company stock is "granted" to an employee.
    • Example: an executive is "granted" an option buy 1,000 shares on January 1st, 2022 at an "exercise price" of $5 per share (see below)

  • Exercising an option: when an employee 'exercises' their right to purchase an option.
    • Example: the executive with options granted on 1/1/2022 "exercises" their rights and buys the shares on July 1, 2022

  • Exercise price: the price the employee pays for their shares at exercise.
    • Example: the executive exercises options for all 1,000 shares at a $5 "exercise price", for a total of $5,000

  • Market value at exercise: the fair market value of the stock price at the date an option is exercised by an employee.
    • Example: at the date of exercise, the fair market value of the company stock is $20 per share

  • Discount element: the difference between the fair market value of the stock at exercise, and the actual exercise price paid by the employee.
    • Example: with a fair market value of $20 per share and an exercise price of $5, the discount element is $15 ($20 market value - $5 exercise price)

  • Offering period: the length of time the employee will be able to exercise the options before they expire
    • Example: the executive's option to buy 1,000 shares expires within 10 years

  • Alternative Minimum Tax Adjustment (AMT) adjustment: this one's really complicated, and only impacts people earning - at the time of this post - over half a million per year if they're single and over a million per year as a couple. So ignore this for now, and if you don't make at least that much, you can ignore it when it mention it later in this post as well.

Now that you know the key terminology associated with ESOs, we can use them to break down the differences and tax implications between the two types available to employees: Incentive Stock Options (ISOs), also known as statutory or qualified stock options, and Nonqualified Stock Options (NSOs). Simply reference the key terms above if you need a refresher as we dig into the details.

Incentive Stock Options (ISOs)

ISOs are the most cherished form of Employee Stock Options because of their preferable tax treatment, and are often offered to high-level execs at startup companies hoping to go public someday.

With incentive stock options, those who meet certain tax requirements can purchase (exercise) their options at a set date (exercise date), for a predetermined price (exercise price), and see no immediate income tax implications for the money they saved by not having to purchase at the stock's fair market value (the discount element).

Let's look at an example:

Even though our employee essentially received a $15,000 discount when buying their company stock, there is no ordinary income associated with the purchase. 

There is, however, an adjustment to the Alternative Minimum Tax calculation, so let's briefly get into what this is.

The Alternative Minimum Tax (AMT) code exists because there are many ways by which a person can reduce the amount of taxes they pay each year using the REGULAR tax code. The IRS wants to ensure that extremely wealthy people pay at least a minimum amount of taxes, so they created another tax code called the Alternative Minimum Tax Code. Each year your taxes are calculated using the regular tax code AND the Alternative Minimum Tax code. In 2022, individuals earning over $539,000 and married couples filing jointly earning over $1,079,800 will see their taxes calculated under both tax codes, and they must pay the HIGHER of the two amounts. And as far as stock options are concerned, the discount element of an ISO is NOT considered income under the regular tax code, but it IS considered income for the AMT calculation.

I don't even want to risk confusing you more than that already has, so let's summarize with this: if you're earning anywhere near the amounts needed to be subject to the Alternative Minimum Tax code, you probably need a professional tax advisor and also a financial advisor. And if you're subject to the AMT code, you definitely need these advisors in my opinion.

Nonqualified Stock Options (NSOs)

Nonqualified Stock Options (NSOs) are also referred to as non-statutory options.

While ISOs are often offered to executives, founders and high-income corporate professionals, many companies with dreams of going public offer NSOs to employees at all levels.

Unlike exercising an ISO, where there is no ordinary income tax applied when you exercise an option at a price lower than fair market value, NSOs do treat the discount value as income.

Going back to our example below, even though the employee exercising their NSO option doesn't receive $15,000 in cash, their tax return for the year will reflect the $15,000 discount as ordinary income.

 

 

 

Now that you understand the impact of purchasing each form of ESO, let's get to the implications of selling these shares, or a disposition.

 

Qualifying Disposition of ISOs

Because ISOs have such favorable tax treatment, you have to be careful when you exercise the options and when you sell any potential shares. If certain requirements are not met, selling stock purchased through an ISO could lead to what's called a disqualifying disposition, which essentially strips the ISO of some of its tax benefits.

Going back to our example, we had an employee who exercised their option to buy 1,000 shares of company stock with a fair market value of $20 at an exercise price of $5, for a $15 discount element. 

Now let's assume that years later, our employee decides to sell the shares when their fair market value is $100, meaning the 1,000 shares our employee purchased for $5,000 are now worth $100,000 (a $95,000 profit).

In a qualifying disposition of shares purchased using ISOs, the entire $95,000 would be treated as a long-term capital gain, which as we covered in our post on Restricted Stock Units, would lead to taxes of either 15% or 20% on the profit.

For ISOs with a qualifying disposition, there will also be a negative AMT adjustment for the same amount that was added to the AMT calculation at exercise. Again, rather than confuse you, if you make over half a mil or so as a single person or a million as a couple, consult with your tax and financial advisor.

So ... What is a Qualifying Disposition?

In order for am ISO Disposition to be qualified, shares have to be sold more than 2 years from the date the options were granted, and more than 1 year from the date the options were exercised and shares transferred.

If it sounds like that means you have to wait three years, you don't. If you exercise your shares as soon as they're granted and then wait two years to sell the shares, you will have met both requirements of 2 years from grant and 1 year from exercise.

There is an additional requirement that the employee must have been employed by the organization at the time the shares were granted, and they must either remain employed at the time of exercise or exercise them within 90 days of leaving the company.

Let's look at two examples that both meet the time requirements for a qualifying disposition.

So ... What Happens If I Have A Disqualifying Disposition?

For ISOs, a disqualifying disposition essentially means turning them into a NSO for tax purposes. Rather than an AMT adjustment for the discount element, it would be treated as ordinary income. And any difference between the sale price of the stock and the fair market value at exercise would be treated as either a short-term or long-term capital gain based on the length of time the exercised shares were held.


 

Disposition of NSOs

Using the same example, our employee sells their 1,000 shares at $100 per share. For NSOs, however, they have already paid income taxes on the discount element they benefitted from in buying shares for $5,000 that were valued at $20,000. Because of this fact, the remaining $80,000 of profit - the difference between the $100,000 sales price and the $20,000 FMV of the stock at the exercise date - will be treated as a long-term capital gain if the stock has been held after exercise for more than one year. If the stock was held after exercise for less than 1 year, this amount would simply be a short-term capital gain.

 

 

What Happens If You Have Options And Your Company Is Acquired?

If you have vested options and your company is acquired, the acquiring company will typically either 1.) give you cash for the value of your options, 2.) replace them with options for stock in the new company, or 3.) cancel them if the exercise price of the options are "underwater", or lower than the FMV of the stock.

What Happens To My Options If The Company Never Goes Public?

Private companies do sometimes offer to repurchase options from employees, which would give them some value to you even if the company doesn't go public.

How Long Do I Have To Exercise My Options?

Incentive Stock Options expire 10 years from the grant date if not exercised. While Nonqualified Stock Options often carry 10 year limits as well, they can vest in a shorter period of time if the company so chooses.

What Happens If I Leave The Company Before Exercising My Options?

Options not exercised within 90 days of leaving a company are forfeited.

All This Sounds Great, But What If I Don't Have The Money To Buy The Stock?

I called stock options a Could Be Yours benefit for a reason; they could be yours if you exercise the option to buy shares ... but what if you don't have the money to do so?

We've been using an example of stock options available for purchase at $5 per share. But the more shares available for purchase and the higher their exercise price, you can run into scenarios where you desperately want to exercise your options but don't have the money sitting around to do so.

Fortunately, there are options available to employees through what's called a cashless exercise. 

A cashless exercise occurs when an employee secures a short-term loan to get the money needed to exercise their option, rather than paying for it themselves. 

After the loan is secured, the employee uses the loan to exercise their option. They then immediately sell the shares and use the proceeds to repay the loan, pocketing the difference between their loan balance and the sale proceeds as profit.

It's important to note that by selling the shares immediately the employee has not met the holding requirements necessary for a qualified disposition under ISOs, or to pay long-term capital gains on their profits under an NSO. As a result, they will be subjected to the harshest taxes. These taxes eat into their gains, but if the cashless exercise is the only way for the employee to find the funds to buy the shares, it can still be worth doing.

Let's look at an example of an employee who needs to find the money to take advantage of an NSO for 1,000 shares of company stock at an exercise price of $100 per share:

With an NSO, the bargain or discount element (FMV of the stock minus the exercise price) is always taxable as ordinary income in the year of exercise. But by selling the shares immediately after purchase, the profit is not only the same as the discount element, but it is also a short-term capital gain. Short-term capital gains are taxed at ordinary income rates.

If we assume that the taxes from the sale would be $120,000, the employee would need to secure a short-term loan to cover both the funds needed to buy the shares and the subsequent taxes, for a total of $220,000.

After selling the shares for $400,000 and repaying the loan of $220,000, our employee is left with a profit of $180,000.

 

In Summary ...

Stock options are one of those good problems to have. They require a thorough understanding of the tax implications, timelines for granting and vesting and as you get into the specifics of your options, there are even features like clawback provisions, which are more than we need to cover in this introduction.

If you have them, read the details regarding them. If you can't understand the details, ask for the help of a professional. But most importantly, hope that those options turn into a once in a lifetime wealth-building opportunity!

In our next post in our series on equity compensation, we turn to another "Could Be Yours" benefit, an Employee Stock Purchase Program.