Employee Stock Options Explained: Guide to Employee Stock Options Terminology
Employee Stock Options Explained: The Ultimate Guide to Employee Stock Options Terminology
Okay, so your company is giving you a stock options award. Congratulations! Now what? The terminology can be overwhelming. Start here with our guide to Employee Stock Options explained. This will hopefully serve as an excellent guide to employee stock options terminology whether you have just received your award or are already familiar with the terms.
Basic employee stock options terms explained
So you’ve opened that employee stock option package envelope and you peer inside – but what you find is totally overwhelming. The first set of vocab for employee stock options explained will cover the basics.
Great! I have a stock option. Now what does that mean?
A stock option basically gives you a choice to buy a stock at a particular price. It can be rewarding when the stock is trading at a price that is above the price at which you get to buy in.
Stock options also define the number of shares that you may purchase at the specified price.
Example: Stock trading at $35/share. Your stock options allow you to buy at $30/share. You save $5 per share on 100 shares, saving yourself $5 x 100, or $500.
There are two types of stock options: incentive stock options and nonqualified stock options. We’ll get into the difference later on in our article.
Exercise (strike) price
In the example above, your stock options gave you the ability to buy a stock trading at $35 at a price of $30. In this case, $30 is what is called the “exercise price” or “strike price" because it is the price at which your trade will be executed.
If you were to exercise the options when the stock were trading over $30 per share, the options would be called “in the money.” You’d save money by doing this.
However, if the stock is trading below $30, it doesn’t make sense to execute the option. You’d be paying more by buying in at $30 than just buying the stock outright in the market.
Do I have a choice? Yes, you do. Employee stock options do not get executed automatically.
As above, when you make the decision to carry out the trade at the exercise price, you have exercised your option.
Employee stock options are only good up until a certain day. You can imagine from the company’s perspective – they have their financials to maintain!
If your stock options expire that means that you lose the ability to execute a trade at the price specified. Does it mean the trade automatically executes? No. No trade is automatically executed at option expiration.
Grant date is the day upon which you are awarded the shares. In between the grant date and the expiration date is the period when you may exercise your options.
Here’s where grant date comes into play. You may not receive your options all at once. You may get them at several points during your tenure at the company. In this case, you want to pay special attention to each group of options (also called a “grant”) so to speak. They may carry different qualities such as exercise price, etc.
The first day that you are allowed to exercise your option.
This is the time when you are allowed to exercise the options. You can exercise in between the vesting date and the expiration date. The vesting schedule may vary for each grant.
A schedule that dictates when you can exercise which grants.
More sophisticated employee stock options terms explained
This part of the guide to employee stock options terminology will cover the moderately sophisticated concepts. The employee stock options terms explained here will tell you more specifics about the types of options you may have.
Incentive stock options
Incentive stock options do not generate taxable income upon exercise. The notional gain you recognize is taxed as a capital gain.
Now, before we get further into the tax treatment of options remember that we are not your accountant or tax advisors so if you have specific questions about your situation please consult with such a professional accordingly.
Let’s discuss an example. If the stock price is $35/share and you exercise at $30/share on 20 shares, the $100 notional gain that you recognize counts as a capital gain when you eventually sell those shares of stock. It depends on how long you hold the shares for after you exercise; you may be liable for a short term or long term capital gain in accordance with the prevailing IRS rules.
Nonqualified stock options
These are typically awarded to executives and differ from Incentive Stock Options in that they do not receive preferential tax treatment.
Nonqualified stock options upon exercise will create a tax event that is equal to the gain that you realize. For example, if the stock price is $35/share and you exercise at $30/share on 20 shares, the $100 notional gain that you recognize counts as taxable income.
This is a term used to refer to any type of stock-based compensation (as opposed to cash-based compensation) that your company gives you. Stock options are one type of equity award. Other types are restricted stock and performance shares.
In a cash exercise of stock options, you buy the shares by handing over the cash to pay for them. But what if you can’t? You may not just so happen to have a huge mound of cash sitting there in your bank account.
In a cashless exercise, you pay for a portion of your new shares by selling some of the other shares of stock you’re entitled to (as opposed to paying in cash). Your brokerage company basically provides a mechanism for you to use your option, then immediately sell just enough stock on the same day to cover the purchase of the remaining shares.
Early exercise/Exercise period
Let’s say that you are granted stock options that vest next year. What if you don’t want to wait until next year?
You can exercise early (if your company allows it), meaning that you pay the exercise price for the shares; thus, locking in the stock price and starting a capital gains holding period. Done? Game, set, match?
Well, not exactly.
You don’t technically own the shares until the vesting date; the company can repurchase the shares in some circumstances.
Plus, you had to pay for the stock somehow, either with cash or a promissory note – so you have capital at risk if the stock value declines (and perhaps accrued interest to pay as well).
Advanced employee stock options terms explained
This is a guide to some of the more advanced employee stock options terminology. These employee stock options terms explained will fill you in on valuation, taxation, and capital structure.
Fair Market Value (409A Valuation)
A 409A valuation, or fair market valuation, is done by an independent company (not the firm who issues the options or anyone else that it does business with). It is an assessment of the value of a share of the company’s stock.
This is necessary to carry out if the company is a private company. Because its shares don’t trade on an exchange, there is no other objective way to set the value of a share of the company’s stock.
Under an 83(b) election, you can pay taxes on all the restricted shares granted to you at the time they are granted (as opposed to when they are exercised). People do this because they think the value of the stock is going to increase, hence rendering them a bigger tax burden.
AMT, or Alternative Minimum Taxes, are supplemental taxes that are levied on certain types of income. You may be liable for AMT if you exercise incentive stock options or ISOs. Remember in the example we cited how you were granted option to buy the stock at $30 and you exercised when it was trading at $35?
In this scenario you’d own AMT on the $5 gain you recognized.
Given the passing of the Tax Cuts and Jobs Act, AMT is much less of a concern than it has been in the past, but if the Act is repealed, you will most certainly want to plan for AMT.
An option pool is a way for companies who are just starting out to attract and retain good employees. Basically, it gives the company a way to pay its people other than by cutting them a check. The company will assign a part of its value as eligible to be owned by its employees, and sets it aside. Then it divides it up into shares and issues those to its employees. Usually the employees who joined the company earlier get a larger portion of the option pool than those who joined later.
When your company grants you stock options, it’s a good idea to try to understand the capital structure that is in play. After all, a share of stock is essentially a stake in the capital of the company you work for!
You want to know the number of shares outstanding so that you can conceptualize your percentage ownership of the company. So you look in the paperwork and find out the number of shares outstanding. Easy enough?
If you only know the amount of shares issued and outstanding, you may be in for a surprise. The company may have options that are issued but not yet exercised. This can be very misleading and potentially unpleasant.
Issued, but not exercised, shares won’t be counted yet; but if at some point they do become exercised, now there’s a dilution effect potentially going on. The company’s capital is now spread out amongst a higher number of shares (aka the dilution effect). And that can be pretty harmful if you’re planning your life around these options (retirement, purchase of a house, supporting a family, etc).
However, if you were to find out the fully diluted shares outstanding, this is all taken into account. The company has to tell you the number of shares assuming that all preferred stock, warrants, and options were to become exercised and exist as common stock shares. It shows you a bigger picture and generally presents a more realistic picture.
Know how many fully diluted shares exist!
Knowing the company’s capitalization table is another important part of understanding what you’re owning. The table will show all the equity owners across the spectrum of common and preferred stock, warrants, and convertible shares. You’ll also see who owns these shares and at what price.
Cap tables are important because they reveal the true value of the company. Know what you are getting into!
Summary of employee stock options terms explained
Hope you’ve enjoyed our list of employee stock options terms explained. Stay tuned for other guides to employee stock option terminology, taxation, etc. that we’ll be publishing in the future and please contact us with any questions you may have.
About the Author
Chris Jaccard, CFP®, CFA is a lead advisor with Financial Alternatives in La Jolla, CA. When he’s not working on home improvement projects or trying to keep up with his kids, he loves to help successful families consider their alternatives and make better financial choices with the EXPERT™ Advisory Process. Schedule a time to chat about your situation or the latest project.