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How Stock Options Work

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What Are Stock Options?

Stock options are a form of employee compensation and are not actual shares of company stock. Instead, they are equity options offered by companies as compensation that allow employees to purchase stock at a pre-determined rate in the future.

Stock options are frequently offered to employees of startups and can be extremely profitable if obtained early enough and if the startup grows quickly.

How Do Stock Options Work – Breakdown for Employees

If you’re wondering how stock options work, you’re not alone. It can be overwhelming to try to understand all the ins and outs of these equity perks, but luckily, they are not as complicated as you might think.

Here are two examples of how employee stock options work to help you:

  • Carlita is a new employee at a startup. As an incentive to take the job, she was offered 5,000 stock options over a 4 year vesting schedule with the company at a strike price of $5. This means that Carlita will gain the right to purchase 25% of her stock options each year, or 1,250. At the end of the 4-year term, she can purchase all 5,000 stock options for $5 even though the fair market value has raised to $15.
  • When Jaleel signed on with his company, he was granted 1,000 stock options at a strike price of $10 each with a vesting term of 4 years. At the end of the vesting term, the market price for the stock options Jaleel is entitled to dropped to $5. Rather than exercising his right to stock options, he chooses to let them expire, since the previously agreed upon strike price is higher than the stock options are worth.

Check out this article to learn more about how employee stock options work

Key Terms in Stock Options

Understanding the key terms in stock options is essential to comprehend how they work.

Here are the most important terms you need to know:

  • Strike Price : also known as a grant price or exercise price; the price you pay for stock options
  • Exercise Window : the period in which employees are permitted to exercise stock options
  • Vesting Period : the amount of time an employee must wait before they have the right to purchase all their stock options
  • Equity Grant Agreement : the written agreement that establishes employee stock options, strike price, exercise window, and vesting period
  • Non-Qualified Stock Options : also known as NSOs, when exercised, the difference between the strike price and the market price of a stock option is taxed at standard income rates
  • Incentive Stock Options : also knows as ISOs, these options are not taxable when exercised
  • Alternative Minimum Tax : used to calculate taxes for certain ISOs that are paid out to high-yield earners; created to ensure high earners pay their fair share of taxes

Here is an article about all the aspects of employee stock options.

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Different Types of Employee Stock Options

Employee stock options give workers the right to purchase a pre-determined amount of stock at a set price, usually after a specific period known as a vesting period. These options are used as an incentive to bring employees aboard and to retain them in the long term.

There are two main types of employee stock options out there: nonqualified stock options and incentive stock options.

Nonqualified Stock Options

When employees exercise their right to purchase nonqualified stock options (NSOs), there is usually a difference between the strike price and the market price of their shares. With NSOs, the difference between these two numbers is taxed at the standard rate for payroll taxes and personal taxes. Then, taxes are charged again if the stock options are ever sold.

Incentive Stock Options

Incentive stock options , or ISOs, are unique because when employees opt to exercise their right to purchase them, they are generally not taxable under payroll tax, only personal taxes. The only exception to this rule is in the case that an alternative minimum tax (AMT) applies, which requires high earners to pay taxes on options regardless of their type. The AMT is essential to ensuring that high earners pay their fair share of taxes.

Learn more about nonqualified stock options and incentive stock options by checking out this article .

Understanding Vesting for Stock Options

When employers create stock options to offer to their workers, they determine a certain amount of tenure the employees must have before purchasing their options in full. This period is called a vesting period.

Vesting periods are important because they give employees incentive to retain their jobs with the company. Since long-term employees are more knowledgeable in their roles, business leaders find them more valuable than new employees in most cases.

Consequently, vesting periods are set in place to incentivize quality workers to gain tenure in their roles and thus becoming more valuable to the company.

Vesting periods typically last between four and six years. The length of time an employee’s specific period lasts is outlined in the equity grant agreement they sign when accepting their right to stock options.

Learn more about vesting periods by reading this article .

Stock Options and Taxation

Understanding tax rules can be intimidating, but when it comes to employee stock options , taxation is simple. Taxation for stock options can be broken down into three main categories: nonqualified stock options, incentive stock options, and alternative minimum taxes.

Taxation and Nonqualified Stock Options

Nonqualified stock options are known for being taxed at the standard rate. When employees exercise a stock option, there is usually a difference between the strike and market price of any given stock option. Employees pay taxes on the difference between the market price and the strike price of purchased options.

For example:

  • Franco exercises a stock option to purchase 500 shares at a strike price of $5, for a total of $2,500. The market price of the same options is $10, which would be a total of $5,000. Franco is responsible for paying payroll taxes and regular taxes on the difference of $2,500.

Taxation and Incentive Stock Options

When an employee exercises an incentive stock option, employees only pay personal taxes and are excused from paying payroll taxes. Employees are not required to pay the difference between the strike price and the market price at the time of exercising. However, taxes are due on any profits received when selling the options.

Taxation and Alternative Minimum Taxes

When employees exercise an ISO, they are generally not responsible for payroll taxes on the difference between the strike price and the market price. However, certain high-value incentive options can trigger alternative minimum taxes. These taxes are designed to ensure that high earners pay their fair share of taxes.

Find out more about stock options and taxation in this article .

Get Help with Your Stock Options

If you have questions or concerns about employee stock options, you need a qualified professional in your corner. Understanding the ins and outs of employee stock options can get complicated, so it’s always a good idea to have a lawyer on your side. Post a project on ContractsCounsel today to get connected with financial lawyers who specialize in employee stock options today.

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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