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Exercise Stock Options: Definition and How It Works

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What Does Exercising Stock Options Mean?

Employees that receive stock options as part of their compensation package will hope to exercise them one day in the future. Exercising stock options means purchasing the option stock granted to you at the exercise price , grant price , or strike price , which means you now own common stock of the company. Prior to exercising your stock options, you did not technically own common stock in the company.

The reason you would hope to exercise your shares is because they would have increased in value since they were granted to you. In other words, you stand to make a profit when you exercise your shares since you will be paying a lower price per share (exercise price) than the present-day value.

It does not always make sense to purchase option shares, though. If, for example, the present value of the shares hasn’t changed since the issue date, you may not want to spend the money to purchase them. The company may have also gone out of business, which means the shares are worth zero. Exercising stock options can also have a big impact on your taxes, so it is import to have a plan.

Here is an article about employee stock options.

How Exercising Employee Stock Options Works

Before considering whether it makes sense to exercise stock options, it is important to understand how they work. Employee stock options are used as a tool by employers to hire, retain, and motivate employees to work in the best interest of the company.

In other words, if the employee works hard to create value at the company, they should benefit in the increasing share price in the future. Hiring is also competitive, so if you want to hire the top talent you may need to offer employee stock options.

Here is an article about when you should exercise your stock options.

Understanding Basic Stock Options Terms

  • Exercise Price – The exercise price, also known as the grant price or strike price, is a price set by the issuer that reflects the fair market value of the stock. This is also the price the employee will be able to purchase, or exercise , their stock options in the future.
    • Example for Exercise Price: An employee may issue stock options at an exercise price of $0.50 per share. If the employee ever chooses to exercise the stock options after they have vested, he will hope the stock price is much higher than $0.50 per share, since he will have the ability to buy the options at $0.50 per share even if they are now worth $20 per share.
  • Grant Date – The grant date is the day the issuer of the stock options grants them to the employee. This date is typically listed on the stock options agreement the employee signs as part of their employment contract.
    • Example for Grant Date: If an employee signs an options grant on January 1, 2020, the grant date is most likely January 1, 2020 since it will be listed on the agreement and become legally binding upon signature.
  • Number of Shares – The number of shares is the number of stock option shares the issuer is granting to the employee. These are the shares the employee may have the opportunity to buy in the future.
  • Exercise Method – The exercise method is the way the employee will be required to pay for the shares in the future, should the employee choose to exercise them. Cash and stock swaps are two forms of exercise methods.
  • Vesting Schedule – The vesting schedule outlines the timeframe the employee will need to stay with the company in order to earn the right to buy the options.
    • Example of Vesting Schedule : It is very common to see a four-year vesting schedule with a ‘one year cliff’. This essentially means:
      • All stock will be vested after four years of service at the employer.
      • The employee needs to work a minimum of one year for any stock to vest.
      • After one year of service, the remaining stock will vest incrementally on a monthly or quarterly basis.
    • Expiration Date – The expiration date is the day which the employee will no longer have the ability to buy the option shares. This is typically years after the grant date.

Here is an article on vesting stock.

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Exercising Example With Numbers

Now that we’ve gone over the key terms for employee stock options, let’s go over an example that explains how exercising works.

  • Joyce is hired at a new startup and is offered 10,000 option shares at an exercise price of $1 per share.
  • Joyce’s vesting schedule is four years with a one-year cliff, after one year the remaining shares vest monthly at 1/36.
    • In short, Joyce needs to stay the company for one year to get any shares at all. If she leaves before, she will have no option shares. After one year, 2,500 shares are vested, after two years 5,000 shares have vested, after 3 years 7,500 shares vested, and after four years she will have all 10,000 shares vested.
  • Joyce ends up staying at the company through all four years, so earns the right to exercise the 10,000 shares if she wants to.
  • The company is then purchase for a price of $10 pe share. This is a great result for Joyce!
  • Joyce will likely choose to exercise her stock options and buy all 10,000 shares at $1 per share (exercise price), so paying a total of $10,000.
  • In return, Joyce receives 10,000 shares which were currently valued at $10 pe share, meaning they are now worth $100,000.
  • Doing simple match, Joyce has earned a $90,000 profit ($100,000 - $90,000).

Here is an article that has another example of how exercising stock options work.

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Types Of Stock Options

There are two different types of employee stock options, which are below:

  • Incentive Stock Options (ISO) – ISOs are stock options that have the ability to qualify for preferential tax treatment. For this reason, ISOs are also known as qualified stock options.
  • Non-qualified Stock Options (NSOs) – NSOs are the most common and, as their name infers, do not qualify for special tax treatment from the Government.

Here is an article where you can read more about incentive stock options.

Here is an article where you can read more about non-qualified stock options.

Stock Options At Startups

Employee stock options are commonly offered as part of compensation packages for early employees. Startup founders want early employees to work as hard as possible to make sure the startup is a success, and there is no better way of doing that then allowing them to enjoy the upside if the startup becomes super successful.

Exercise prices can often be very low for startup stock options since the shares are worth very little at the beginning of a startup’s life. This allows for potentially huge returns by early employees.

Exercising Stock Options After Leaving Company

Many people jump from startup to startup and often leave a startup with some options vested. You can only exercise your stock options before your past employer’s post-termination exercise period ends. Once this period end, you will no longer have the ability to exercise your options and they simply go back into the company’s option pool.

Here is an article on startup stock options.

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How Stock Options Are Taxed

The most important thing to remember is you become liable for taxes once you exercise your options. Prior to exercising, you do not need to pay taxes on your stock options because you do not own them. Your tax rate will be dependent on what type of options you hold.

  • Non-qualified stock options : NSOs are taxed at ordinary tax rates.
  • Incentive stock options : ISOs qualify for preferential tax treatment and can be taxed as capital gains rates.

If you want to better understand tax implications for your options, feel free to browse our tax lawyers .

Here is an article that has a table with the difference in tax liability between ISOs and NSOs.

Who Can Help With Stock Options

If you have any questions about exercising your options or employee stock purchase plans, feel free to post a project and receive free bids to review your agreement from qualified lawyers.

ContractsCounsel is not a law firm, and this post should not be considered and does not contain legal advice. To ensure the information and advice in this post are correct, sufficient, and appropriate for your situation, please consult a licensed attorney. Also, using or accessing ContractsCounsel's site does not create an attorney-client relationship between you and ContractsCounsel.

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