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You have employee stock options, but you don't know what they are or how you're supposed to use them. You don't need to take a course or buy an expensive "how to" guide to understand.
While stock options can be extremely complicated, they’re pretty easy to understand once you know the basics of how they work — and you should.
Employee stock options are becoming a more common form of compensation as the number of startup companies grow. Understanding them is the first step to maximizing their value.
What Is an Employee Stock Option?
An employee stock option is a form of compensation sometimes included in compensation packages. Many startups use employee stock options as a way to attract talented workers and instill a stronger sense of loyalty to the company in them. When employees have the ability to buy company stock at a discount, they’re going to want the company to succeed.
Stock options give an employee the option to buy stock in the company for a particular time period at a set price. Each option allows you to buy one share of stock.
If you get hired at Startup A, you may be offered 10,000 stock options that you can exercise over the next 10 years. To exercise each one of your 10,000 stock options, you’d have to pay $1. This $1 is the strike price.
It would be great if you could exercise your stock options immediately after you’re hired, but most stock option programs require that you earn the right to exercise the options over time. You may be granted the stock options immediately, but you don’t get full ownership until a future date. This is called vesting. The vesting schedule, sometimes called a vesting period, dictates when you’ll earn access to your options.
You can only exercise your options once you own them.
At Startup A, let’s say the vesting schedule says you’ll earn ownership over 20% of your stock options for each full year of service at a company. That means you’ll earn 2,000 options each year for 5 years until you’re vested in all 10,000 stock options.
How do employee stock options work as compensation?
When you exercise your option, you purchase a share of the company.
In the above example, your options cost you just $1 to exercise. As long as the company’s shares are worth more than $1, you have the potential to make money on your options.
If the stock is worth $10, exercising your option would add another extra $9 to your net worth. But you can’t always sell company stock. More on that later.
Why Do Companies Use Stock Options?
Companies use stock options for many reasons. Stock options give employees the right to own part of the company, usually at a discounted price. This way a company can give employees extra compensation without having to pay in cash.
Instead, the employee has equity in the business. This gives the employee motivation to help the company succeed. When the company’s value grows, so does the value of stock options the employee holds.
Stock options may be used to attract motivated, talented workers who want to earn a portion of the growth they stimulate for the company.
The Difference Between Stock Options and Stocks as Payment
It’s important to recognize that receiving stock options and receiving stock as direct compensation are two different things. But what’s the difference?
If a company offers to pay you in shares of stock, you’ll be paid in actual shares of stock—not the opportunity to buy a stock at a discounted price.
Remember: an option gives you the ability to purchase a share of stock but does not actually give you the stock. A person has to become vested in their options, exercise their options, and buy shares before they own the stock.
Your Employee Stock Options Explained
Before you do anything else, you need to understand how your stock options work.
First, you should make sure that you understand your company’s stock option plan. In particular, make sure you read and understand the document that governs your stock option plan. What’s the vesting period? Is the company public or private? Who can you sell to?
You also want to make sure you understand the specifics of the stock options you’re granted. Make sure you understand the strike price, the specific number of shares your options can purchase, and any vesting period that may apply.
Once you understand these concepts, you can move on to the potential value of your options.
How Should You Value Stock Options?
To figure out the potential value of your options, you’ll need to know if the company offering you options is publicly traded or not. Publicly traded means that stock for your company is already on the market. A company that isn’t publicly traded is considered “private” and may have some more rules surrounding its options.
If your company’s stock is publicly traded, you can compare the strike price of your options to the market price of the stock. This will give you an idea of how much you stand to gain from buying and selling the shares.
Of course, your stock options may not vest right away. If they don’t, the market price of your company’s stock will be different by the time your options vest.
You can’t predict the future, but you can make an educated guess. Estimate whether your options will be worth more or less down the road by looking at your company’s future prospects.
If your company isn’t publicly traded, things get more complicated.
Even if you’re able to purchase shares using your stock option, you may be limited when it comes to selling those shares. Private companies often have restrictions on who can and who cannot own shares.
Some companies will offer stock buyback periods that allow employees to cash out their stock, but it’s not a guarantee. If your company never goes public or offers to buy back your shares, you may never be able to sell your stock.
That being said, private companies often get official valuations that help determine the current value of their stock. These valuations give an estimate of how much the company as a whole is worth. This will allow you to calculate the value of your stock options. Of course, valuations can increase and decrease based on how the company performs.
And don’t forget taxes.
Think you’re done when you determine the value? Think again.
After figuring out the value of your stock options, you may need to pay taxes based on the transactions surrounding your stock options.
Will tax impact your bottom line?
To find out, you should consult with a financial advisor or tax professional that deals with stock options on a regular basis. These professionals can look at your stock option plan and figure out if you’ll have to pay ordinary income tax or capital gains taxes on your earnings.
They’ll also be able to give you tips on whether a particular holding period will allow you to pay a lower long-term capital gains tax rate. Incentive stock options may offer favorable tax treatment, so it can pay off to get professional advice.
Stock Options Vs. Restricted Stock Units (RSUs)
Much like stock options, restricted stock units (RSUs) are a form of equity compensation.
Employers grant a number of shares to employees. These shares are set up on a vesting schedule and can be attached to additional stipulations like product launches.
RSUs are intended for employees to take ownership of a company and improve employee retention.
If you’re an employee with restricted stock units, keep in mind that they do not have value until the vesting stage has passed.
Restricted Stock Units Advantages
Restricted stock units are different from stock options and come with some advantages. These include:
- RSUs are simpler than stock options. Many employees may find that they understand the vesting schedule compared to stock options.
- Stock options give employees the option to purchase stocks, but you don’t purchase RSUs. Restricted stock units become yours after vesting.
- RSUs retain market value. With stock options, you have to evaluate the strike price to determine if they are worth purchasing.
- Restricted stock units are more flexible than stock options.
Disadvantages of Restricted Stock Units
There are a few disadvantages of restricted stock options.
Although some companies have deduction options, the biggest downside is worrying about taxes — RSU income is taxed when your shares vest. If you sell your restricted stock unit shares immediately, you won’t have to pay a capital gains tax. The only tax that you’ll be required to pay is on the income. On the other hand, if you decide to hold shares of your restricted stock units past the vesting date, any gain or loss will be taxed as a capital gain or loss.
Example of RSU
Let’s take a look at an example of a restricted stock unit.
Company X offers talent they want to retain RSUs because it encourages them to stay longer and take ownership of work. As part of an employment offer, Emma is offered 500 RSUs with Company X.
Company X’s stock is worth $20 per share, making her offer of 500 RSUs worth $10,000. Part of what helps Company X with retention is the RSU vesting schedule. Their vesting schedule takes five years.
Each year that Emma stays with the company, she receives 100 RSUs, and at the end of her five-year vesting schedule, she now owns all 500 RSUs.
Her RSUs are now worth $30 a share because the value of her company has increased in the market. So her total RSU compensation is currently valued at $15,000 after vesting.
Emma now owns this stock, and she no longer has to stay with the company. She can hold onto her investments or sell them.
Is it better to take RSU or stock options?
When comparing restricted stock units and stock options, many investors may wonder which is better for them.
The simple answer is that it depends on the company. Stock options are usually the better deal for early-stage or high-growth companies because the strike price should be smaller once you’re vested. Employees have the advantage of using stock options rather than the stock exchange.
RSUs are a great option for more established companies because you have a general idea of their worth when you enter the agreement. But as stated before, you do need to be careful of the tax implications that can happen once they are vested.
The Bottom Line: Employee Stock Options
Now that you have employee stock options explained, you can apply this information to your particular situation. If you have friends that are in similar situations, you can save them time and explain it to them.
That way nobody needs to go looking for an employee stock options for dummies course.