Ask Bill about Stock Options

The first question I received was:

My daughter just accepted a position at a high-tech company. The offer for employment included 2,000 stock options as well as an annual salary. Just how do stock options work, and how could the options affect her time with the company?

First let’s talk about how they work from the recipient’s point of view.

A stock option is a right to buy a share of stock at a specified price at some future date or range of dates. While you can also buy and sell options on the open market, the terms of employee stock options are usually different from those you can buy on the open market. Generally there are three critical factors in a stock option offer.

  1. How long before the option can be exercised? That is, how long before the holder can actually use the option? This period is called the vesting period and can vary greatly by company from less than 1 year to as many as 5 years. Generally, if the employee leaves before the vesting period is completed, the employee forfeits all of the options (they get nothing).
  2. What is the exercise price of the option? That is, what is the price they must pay to buy the share of stock the option entitles the holder to purchase? Often employee stock options have an exercise price equal to the stock price on the date the option was granted, but options can also have exercise prices above the grant date stock price or below the grant date stock price.
  3. How long before the option expires? That is, when does the employee no longer have the right to buy a share of stock at the option price? This varies by company as well, but often you see exercise periods of 5 to 10 years. Almost always the exercise period is several years longer than the vesting period discussed on number 1 above.

The basic point of an option is for the employee to share in the benefits if the stock price (and therefore value) of the company increases. The idea is that by sharing in that increase in value, the employee will be incented to help the company increase its value and therefore benefit the stockholders of the company. If the exercise price of the option is $30 and after a period of time, the stock price is $40, then your daughter can exercise the option, buy the share for $30 and turn around and sell the share of stock for $40 and make $10. On the other hand if the stock price is $20, then the option is essentially worthless because no one would pay $30 for a share of stock they could simply go out on the market and buy for $20. And that is the issue with stock options as compensation. They are great and do an excellent job of retaining employees because no one wants to leave if the stock price goes up, but they are lousy and have no retention benefit at all to the company if the stock price goes down.

When it comes to actually exercising options, many employees don’t have thousands of dollars sitting around to buy the shares (per the example above 2,000 shares at $30 per share would cost $60,000) before they turn around and sell them, so companies often set up “cash-less” exercise programs. These programs essentially allow the employee to exercise the options and get paid the difference between the exercise price and the current stock price. In the example above, with an exercise price of $30 and a stock price of $40, if she exercised all 2,000 options in such a program she would receive $20,000 (the difference between the current value of the stock $40 * 2,000 shares and the payment she would have to make to buy the stock $30 * 2,000 shares). Of course she would have to pay income tax on the $20,000 and almost all cash-less exercise programs include automatic withholding of taxes so she would only get the after tax amount, not the full $20,000.

There are many financial and tax planning opportunities around options. Should you exercise the option as soon as it vests or wait for it to continue to go up in value until the very last day it can be exercised? Of course it can also go down in value (remember the stock market crash of 2008). Should you actually buy the stock rather than take advantage of the cash-less exercise program and then hold onto the stock for a period of time in an effort to turn some of the taxable income into capital gains income rather than ordinary income (which is generally taxed at a higher rate than capital gains in today’s tax rules)? Of course, if you don’t have $60,000 sitting around, this may be a moot point.

2,000 options is probably not enough to get really serious and seek expert financial advice on what to do, but if she continues to move up in the company and is granted additional options that become worth a considerable sum of money, she should seek out advice from an expert such as a CPA or a CPA-PFS (a Personal Financial Specialist credential offered only to CPAs) to help her work through the financial and tax planning aspects of the options.

Next week I will talk about how options work from the company’s point of view.

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