Do you own stock options from a current or previous employer? Understanding what employee stock options are, how they work, and how to handle them can help you get the most out of them.

Employee Stock Options Explained

Employee stock options aren’t actually shares of stock. Instead, they are the right given to you to purchase a certain number of stock shares at a set price, called a strike price, during a specific time frame. The options vest after an initial period of time and for a defined number of years. After they vest and before they expire, you can use them to buy the stock at the strike price. You can either retain the shares you have just purchased or sell them. When you exercise the options and purchase the shares, you will realize a financial gain when the price has increased in value during this timeframe. However, if the stock has fallen in price from the strike price, you simply do nothing. The options expire without any financial payment due from you.

Employee stock options allow employees to feel more connected to their company and offer increased compensation potential for little risk. They are popular with startups that want to reward early employees prior to going public and for established companies that want to encourage employee longevity and tenure. And, they give employees a chance to benefit if the company performs well.

1. How Stock Options Work

Let’s say that you are given stock options to buy 100 shares of your company’s stock at $10 a share.

Example One:

• The options vest over five years until you fully own them.
• Once you’re vested, you have another two years before they expire.
• Within those two years, you can choose to exercise your options.
• The stock has increased from $10 a share to $20 a share.
• You exercise the options:
• With cash: You can buy the stock with your own money at the option price of $10 a share, owning $2000 of stock for $1000, and it is yours to hold or sell afterward; or
• Without cash or “cashless exercise”: You can make an exercise and sell transaction: the brokerage effectively fronts you the money and uses the money made from the sale to cover what it costs to purchase the shares, leaving you $1000 afterward (before taxes and fees, if applicable).

Example Two:

• The options vest over five years until you fully own them.
• Once you’re vested, you have another two years before they expire.
• Within those two years, you can choose to exercise your options.
• The stock has dropped from $10 a share to $5 a share.
• You don’t exercise the option because it has lost value.
• The options end at the expiration date, with nothing owed and no action needed.

If your stock options have followed Example One (rising in value) and you decide to exercise your options but keep the stock instead of selling it, experts caution that it can be risky to have too much of your net worth dependent on one company, “concentration risk”. You should speak to a financial advisor and your tax advisor to determine what is in your best interest. At Stonecrop Wealth Advisors, we routinely work with clients to determine the right decision that won’t jeopardize their financial future.

2. Taxes and Stock Options

Companies generally issue one of two types of stock options which differ in how they treat taxes:

• NSO or Non-Qualified Stock Options: With NSO options, the difference between the strike price and the exercise price ($20 – $10 = $10 in the example above) is taxed as ordinary income.
• ISO or Incentive Stock Options: With ISO options, they are not taxed when exercised unless you are subject to AMT (alternative minimum tax) and qualify for long-term capital gains tax rates if held for more than two years from the grant date and one year from the date of exercise.

ISOs, in particular, can benefit from review by a financial advisor and a tax advisor to ensure that your tax situation is carefully evaluated.

3. When To Exercise Your Employee Stock Options

Once you’re fully vested in the options, you should speak to a financial advisor before making any decisions to exercise them. You’ll need to consider the risk (if you keep shares in your company, for example), tax planning (such as if it’s an ISO), and the correlation with the rest of your portfolio.

Receiving employee stock options could offer you surprising and unexpected money. What will you do with it? Will it be used for something you’ve dreamed about, such as a special trip? Will you put it toward your children’s education or add it to your retirement plan? Will you use it to help others? It may also make sense to talk to a financial advisor about the best way to pursue your plans.

Stonecrop Wealth Advisors Can Help

As a full-service financial and investment advisory firm that works with individuals, families, and non-profit institutions, we help you connect your money to your purpose. Then we take your resources and put them on a path towards a more prosperous future.

Our mission to help you is what motivates us. We seek new clients because we believe you will benefit from what we do and how we do it. And nothing makes us happier than when our clients can do more than they thought they could, and their ability to do good and to be generous toward their families and communities is expanded. Receiving employee stock options offer clients another opportunity to support their mission. We can help ensure you get the most out of this compensation.

Like to find out more about Stonecrop and our financial planning services? Sign up for our weekly eNewsletter, MacGray Matter, from our president, Douglas MacGray or connect with us here. Either way, we look forward to sharing more about our ‘wholistic’ methods with you.