ContractsCounsel Logo
Home Blog How Stock Options Work

How Stock Options Work

Jump to Section

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.

Meet some lawyers on our platform

Darryl S.

75 projects on CC
CC verified
View Profile

Ryenne S.

671 projects on CC
CC verified
View Profile

Zachary J.

387 projects on CC
CC verified
View Profile

Jeremiah C.

108 projects on CC
CC verified
View Profile

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.


How ContractsCounsel Works
Hiring a lawyer on ContractsCounsel is easy, transparent and affordable.
1. Post a Free Project
Complete our 4-step process to provide info on what you need done.
2. Get Bids to Review
Receive flat-fee bids from lawyers in our marketplace to compare.
3. Start Your Project
Securely pay to start working with the lawyer you select.

Meet some of our Lawyers

Umar F. on ContractsCounsel
View Umar
5.0 (1)
Member Since:
April 24, 2024

Umar F.

Startup Legal Counsel
Free Consultation
New York
16 Yrs Experience
Licensed in NY
University at Buffalo School of Law

Hi, I'm Umar from CounselX. I started off doing domestic and international corporate law work at the world's largest law firm Dentons and then moved in-house as Head of Legal of an investment bank before starting my own firm in 2012. We have been a trusted legal resource for founders since our inception. My team has helped over 1,000 startups launch, grow and thrive. When it comes to corporate and commercial law matters, you need an attorney that not only has a deep understanding of the law, but is passionate about your companys continued success. Whether it's helping to get your business off the ground or handling tough negotiations in a pivotal transaction, I'm available to provide insightful legal counsel and trustworthy guidance. To learn if I'm the right fit, schedule a free 15-minute introductory call with me.

Laura H. on ContractsCounsel
View Laura
5.0 (1)
Member Since:
May 2, 2024

Laura H.

Lawyer
Free Consultation
Massachusetts
17 Yrs Experience
Licensed in MA
Pacific McGeorge School of Law

Massachusetts attorney with more than 15 years experience. I assist with family matters, consumer protection, HOA disputes, and small claims court. Virtual assistance available state-wide. LGBTQ+ friendly.

Romina S. on ContractsCounsel
View Romina
Member Since:
April 18, 2024

Romina S.

Managing Attorney
Free Consultation
Morristown, NJ
18 Yrs Experience
Licensed in NJ, NY
St. John's University School of Law

Attorney licensed in New York and New Jersey with over 15 years of experience in Real Estate, Property Law and Collection/Debt Defense Law.

Darren S. on ContractsCounsel
View Darren
Member Since:
April 25, 2024

Darren S.

principal attorney
Free Consultation
Southern California
30 Yrs Experience
Licensed in CA
UC Hastings College of the Law

Practiced civil litigation and bankruptcy law for 30 years.

Jocelyn W. on ContractsCounsel
View Jocelyn
Member Since:
April 21, 2024

Jocelyn W.

Attorney
Free Consultation
Venice, CA
11 Yrs Experience
Licensed in IL, MN
Vermont Law School

Jocelyn A. Walters-Hird focuses her practice on conservation law and other real estate matters. She has provided counsel on dozens of conservation easement transactions as well as fee sales and acquisitions, including the structuring, negotiating, and closing of such projects. Prior to joining the conservation community, Jocelyn worked as a litigator, which has informed her approach to drafting workable documents and resolving post-transaction issues. With both in-house counsel and private practice experience, Jocelyn has a unique skillset allowing her to problem solve and provide sound legal advice to land trusts, landowners, and other organizations. She is the former Sr. Staff Attorney at the Minnesota Land Trust, where she led the legal team of the state’s largest non-profit land trust. She also worked as Attorney for Conservation Partners, LLP, a nationally-recognized boutique law firm that has assisted land trusts and landowners in protecting hundreds of thousands of acres of land. Jocelyn now serves as Contracted Counsel for the firm.

Ryon D. on ContractsCounsel
View Ryon
Member Since:
May 2, 2024

Ryon D.

General Attorney
Free Consultation
Washington DC
3 Yrs Experience
Licensed in DC
University of the District of Colombia David A. Clarke School of Law

As an esteemed attorney based in Washington, D.C., I bring a wealth of experience and expertise to the legal arena, specializing in a broad spectrum of legal areas including contract drafting, legal research, motions drafting, family law, and criminal law. I earned my Juris Doctor degree from the University of the District of Columbia, where I honed my skills and knowledge in the intricacies of the law. With a solid foundation in both theoretical understanding and practical application, I am equipped to handle the diverse needs of my clients effectively. Throughout my career, I have demonstrated a steadfast commitment to delivering exceptional legal services tailored to each client's unique circumstances. Whether it's crafting airtight contracts, conducting thorough legal research, or advocating vigorously in court, I am dedicated to achieving favorable outcomes for those I represent. My passion for justice, coupled with my dedication to upholding the principles of fairness and integrity, drives me to provide top-notch legal representation for individuals and businesses alike. With a keen attention to detail and a strategic approach to problem-solving, I am well-equipped to navigate the complexities of the legal system and advocate tirelessly on behalf of my clients. I take pride in my ability to build strong, trusting relationships with my clients, guiding them through every step of the legal process with compassion and professionalism. Whether you're facing a challenging legal issue or seeking proactive legal guidance, I am here to provide the skilled representation and personalized attention you deserve. Contact me today to schedule a consultation and take the first step toward resolving your legal matters effectively and efficiently.

Thomas C. on ContractsCounsel
View Thomas
Member Since:
May 3, 2024

Thomas C.

Attorney
Free Consultation
New York, NY
20 Yrs Experience
Licensed in NY
Brooklyn Law School

I’ve been an attorney for over 20 years practicing mainly in the insurance industry. I’ve worked for law firms, insurance carriers, and insurance brokerages. I currently have my own firm where I help companies manage risk, insurance coverage issues and other business related matters.

Lisa C. on ContractsCounsel
View Lisa
Member Since:
May 8, 2024

Lisa C.

Attorney
Free Consultation
Chicago, Illinois
27 Yrs Experience
Licensed in IL
Northwestern Pritzker School of Law

Lisa Copland Gordon is a seasoned litigator who has practiced law in Illinois for over 25 years. She is a graduate of Northwestern Pritzker School of Law, with a concentration in Civil Litigation and Dispute Resolution. Lisa earned her undergraduate degree from Princeton University. Lisa provides counsel to clients in real estate matters including purchasing, selling, HOA and lease issues. She also represents clients and small businesses in all Cook County courthouse locations.

Jazmin M. on ContractsCounsel
View Jazmin
Member Since:
May 8, 2024

Jazmin M.

Business Lawyer
Free Consultation
Norfolk, Virginia
3 Yrs Experience
Licensed in VA
Regent University School of Law

Hi, I'm Jazmin M. Allen, Esq., your local, 757 Hampton Roads Business Lawyer & Brand Publicist. I am on a mission to help entrepreneurs and new business owners form their business entities, develop their business plans, market their brands, and protect their billion-dollar ideas.

Harry R. on ContractsCounsel
View Harry
Member Since:
May 12, 2024
Judy R. on ContractsCounsel
View Judy
Member Since:
May 18, 2024

Judy R.

Attorney
Free Consultation
Columbus Ohio
25 Yrs Experience
Licensed in OH
Capital University Law School

I am passionate about legal research and writing. I have excellent research and writing skills. My entire legal career has centered around fact-finding, contract and statute interpretation, legal analysis, as well as legal research and writing.

Find the best lawyer for your project

Browse Lawyers Now

Quick, user friendly and one of the better ways I've come across to get ahold of lawyers willing to take new clients.

View Trustpilot Review

Need help with a legal contract?

Post Your Project

Get Free Bids to Compare

Hire Your Lawyer

CONTRACT LAWYERS BY TOP CITIES
See All Startup Lawyers
STOCK OPTIONS LAWYERS BY CITY
See All How Stock Options Work Lawyers

Contracts Counsel was incredibly helpful and easy to use. I submitted a project for a lawyer's help within a day I had received over 6 proposals from qualified lawyers. I submitted a bid that works best for my business and we went forward with the project.

View Trustpilot Review

I never knew how difficult it was to obtain representation or a lawyer, and ContractsCounsel was EXACTLY the type of service I was hoping for when I was in a pinch. Working with their service was efficient, effective and made me feel in control. Thank you so much and should I ever need attorney services down the road, I'll certainly be a repeat customer.

View Trustpilot Review

I got 5 bids within 24h of posting my project. I choose the person who provided the most detailed and relevant intro letter, highlighting their experience relevant to my project. I am very satisfied with the outcome and quality of the two agreements that were produced, they actually far exceed my expectations.

View Trustpilot Review

How It Works

Post Your Project

Get Free Bids to Compare

Hire Your Lawyer

Want to speak to someone?

Get in touch below and we will schedule a time to connect!

Request a call

Find lawyers and attorneys by city