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 their 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 ida 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 guaranteegaurantee. 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.
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.
Lance Cothern is a WealthFit Contributor. He's a freelance writer and founder of the personal finance blog Money Manifesto. He also holds a Certified Public Accountant license in the Commonwealth of Virginia.