What are Employee Stock Options?
Employee stock options are the right given to an employee of a public or private company to purchase shares of the company at a given price (Strike Price or Exercise Price). Their purpose is to give the employees an incentive to work hard and stay with the company by giving them the opportunity to become shareholders, thus aligning the interests of the employee and the company.
Important Information on ESOs
- Stock option Grant and Plan
- Types of Employee Stock Options
1. Stock Option Grant and Plan
When granted Employee Stock Options, you will receive a stock option grant. There are 5 important takeaways from this document: the number of options granted, your exercise (strike) price, the type of options you're receiving, your vesting schedule, and your expiration date.
Knowing the number of options granted and the exercise price of your shares is the easiest portion of the grant. You will have the option to purchase X number of shares at the exercise price of $Y. Knowing what type of shares you have, as well as your vesting schedule is a little more complex, but is essential to fully understand your employee stock options.
2. What type of options do I have, and what does that mean?
If you work for a public company, you typically receive either an Employee Stock Purchase Plan (ESPP) or an Employee Stock Option Plan. Under an Employee Stock Purchase Plan, employees have the option (not obligation) to contribute through payroll deductions in order to purchase Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs). The money deducted from your payroll will be used to buy shares of the company at a discounted price (typically around 15% of market value). Stock Options are not to be confused with an Employee Stock Ownership Plan, in which employees are typically given stock over time with no upfront costs. Once the employee leaves the company, the company will effectively purchase the shares from the employee at their market value at the time and assume control of the shares.
Similarly to a publicly traded company, if you work for a private company, there are 2 types of employee stock options that you can receive in a grant, ISOs or NSOs, and they differ mainly with regards to taxes. Both ISOs and NSOs are taxed based on the spread between the current Fair Market Value (FMV) of the stock and your exercise price at the time of exercise. Neither are taxed until you decide to exercise your options and purchase the stock. You may also receive RSUs, which are not stock options and are treated differently than ISOs or NSOs.
3. Stock Option Vesting
The next important pieces of information to understand regarding your employee stock options are your vesting schedule and your expiration date. These define when you will be able to purchase your options and how long they will be available for you to purchase.
Within your employee stock option grant you will receive an outline of your vesting schedule. The first important aspect of the vesting schedule is the vesting rate or the vesting term. The total number of options granted to you are divided and will vest over a certain time period. A typical vesting schedule is a 4 year, monthly vest; meaning that you vest 1/48 of the total option grant each month (1/12 of the year * 4 years vesting term). If your options vest bi-annually or over 5 years, simply adjust the formula to determine how many options vest per month.
The second important part of the vesting schedule is your vesting cliff date. This is the first date that any of your options become vested or the first point where you can exercise your options. Even though you technically vest options in your first year of employment, the Cliff serves as the point at which you are able to purchase your vested options. This Cliff Date is typically 1 year after the issue date of the grant or the Vesting Calculation Date and serves as an incentive for employees to stay at companies for longer periods of time. For example, if you vest your potions
The next important piece of information is the rate at which your shares vest following this Cliff Date. Outlined below is an example of a typically vesting Schedule for 200,000 options.
4. Stock Option Expiration
This is simply the last date that you can exercise your options. After this date any unexercised options will be null. Typically, your options will expire 10 years after your Vesting Calculation Date, but if you leave the company your expiration date will be sooner.
- ISOs will expire 90 days after you last day at the company, and can not be extended beyond that date without converting to NSOs.
- NSO expiration dates will be dictated by your company, and can be extended well beyond 90 days.
- RSUs will not expire until your expiration date, even if you leave, however it is possible to convert them into shares of the company, which will have tax implications.
- Public company stock options will typically be cashed out upon leaving the company.
5. Exercising Employee Stock Options
The amount needed to exercise your stock options is equal to the number of options multiplied by the exercise price. For example, if you have 1,000 options with an exercise price of $1 it will cost you $1,000 to exercise.
Nowadays most companies use online equity portals such as Carta for everything from housing documents to tracking value and exercising. If your company does not use an equity portal, you will likely need to contact the stock controller or HR for instructions on exercise, which typically includes filling out an option exercise form and submitting payment either via check or bank wire. Once exercised, options turn into shares and you become a partial owner of the company.
Prior to exercising stock options, employees should gather pertinent documents and information in order to fully understand the implications of their exercise. Documents include: Stock Option Grant, Stock Option Plan, Option Exercise Notice, and exercise instructions.
The most important information when exercising is the number of vested options, exercise price, and current fair market value. Using this information, an employee with ISOs can calculate their potential AMT tax impact. US-based employees with NSOs will need to find out their exact NSO tax withholding, either via checking their equity portal or emailing the company.
6. How are my employee stock options taxed?
Employee Stock Options are not taxable when granted (Except for RSUs which are taxed differently). ESO taxation begins when the options are exercised, and taxes are calculated based on the spread between the current Fair Market Value (FMV) and the exercise price.As mentioned earlier you are taxed differently depending on what type of options you own, however the way taxes are calculated, and the cost of exercising remains the same.
Based on the prior example (1,000 options with an exercise price of $1):
If the current FMV is $2 your taxable income will be $2 - $1 = $1 per share,thus your taxes will be based on $1,000 of income (then adjusted depending on the applicable tax rate). It is easy to see how exercising stock options can charge a hefty price, thus why it often makes sense to exercise your options with The Employee Stock Option Fund to preserve your cash and avoid unnecessary personal risk.
Employee stock options are also taxed upon sale. If the sale occurs within 1 year of exercise, they are taxed as short-term capital gains (ISOs sold within a year of exercise will not be subject to AMT). Any sale taking place beyond one year of exercise is subject to the lower long-term capital gains rate. Sales could include secondary market sales, company buybacks, or post IPO/M&A sale of the stock.
When exercising an ISO, you will receive a Form 3921 “Exercise of an Incentive Stock Option” from your employer which will contain the information required to report your taxes associated with the exercise. When exercising NSOs, you will report this as ordinary income on your W-2 Form. When exercising NSOs or settling RSUs employees may elect to defer recognition of income for tax purposes for up to 5 years by filing an 83(i) Election.
At the sale of any shares you own, you will receive a Form 3922 “Transfer of Stock Acquired Through an Employee Stock Purchase Plan” from the company which will outline your gain/loss as well as whether the income is considered capital gains or ordinary income.
Overall, given the complex taxes associated with your employee stock options, it is advised to consult with your tax adviser about how you will be affected.
When working for a privately held company, all these taxes and exercise costs bring up the important question of when to exercise. While there is usually no simple answer given the risky nature of the asset, there are some scenarios you should be aware of prior to deciding.
For more information on how to monetize your private company equity, please contact us at the Employee Stock Option Fund.