For employees who receive them as part of their compensation, employee stock options are a great opportunity to participate in the success of their employer. For total rewards professionals who must discuss them every time an employee is hired or promoted or terminated, employee stock options can be a complex, confusing, and difficult subject to explain.
Most TR pros never receive any formal training on employee stock options and most available information is put forth by someone with no expertise on the subject or by someone who has a conflict of interest. The following is an unbiased guide to understanding the fundamentals of employee stock options.
- Stock: Owning a share of stock in a company makes one a part owner of that company. If someone owns a share of Apple stock, they are a part owner of Apple Inc. If they own a share of stock in a private company called Digital Widget, they’re a part owner of Digital Widget.
For public companies like Apple, the price of a share is determined in public stock markets between buyers buying and sellers selling. For private companies like Digital Widget, the price (also called fair market value or FMV) of a share is determined by an independent valuation firm the company hires each year to perform what is often referred to as a “409a valuation,” noting the Internal Revenue Code section involved.
- Options: An option is the right, but not the obligation, to buy a share of stock at a specified price for a specified period of time. An employee stock option allows an employee— but doesn’t require them — to pay the exercise price for a share of their employer’s stock until the option expires. They pay the exercise price for a share of stock regardless of what the share price is at the time.
There are two types of employee stock options: incentive stock options (ISOs) and non-qualified stock options (NQSOs or NSOs). They function the same way, but ISOs may get more favorable tax treatment.
- Spread: The spread equals the share price minus an employee’s exercise price. If the price of a share of stock is currently $7 and an employee’s exercise price is $5, then $7 minus $5 = a $2 spread. Exercising one of their employee stock options at that point would allow the employee to pay $5 for a share that’s worth $7. While the employee’s exercise price doesn’t change, they’d like the share price to increase over time to increase the spread.
- Grant Date: This is when an employee is awarded employee stock options — usually when they’re hired, they are awarded or granted employee stock options by the company’s board of directors.
- Vest Date: This is when an employee has met the criteria — usually based on time as an employee at the company — set forth by the employer necessary to control and be able to exercise their employee stock options.
- Exercise Date: This is when an employee chooses to use their employee stock options to buy shares of stock in their employer. They can exercise any or all of their vested employee stock options. Note: The spread at the time of exercise of an employee stock option is a consideration for income taxes.
- Sale of Stock Date: This is when an employee sells a share of stock that they received from exercising an employee stock option. At a public company, they can sell shares in public stock markets. At a private company, they’ll typically only be able to sell shares after there’s been a liquidity event, such as a sale of the company or an initial public offering (IPO). Note: The amount of gain (or loss) from the sale of a share of stock is a consideration for income taxes.
- Expiration Date: This is when employee stock options are no longer valid (often 10 years from grant date).
- Exercising one’s vested employee stock options means spending one’s own money to buy shares. At a private company, an employee is risking their own money, as many private companies cease operations and many more never have a liquidity event.
- The probability of a private company having a liquidity event is lower earlier and higher later. Three founders who launch their startup today have no idea if their company will ever have a liquidity event. Three founders whose company is scheduled to have an IPO next week are almost certain there will be a liquidity event.
- Income taxes on the exercise of vested employee stock options are usually lower earlier and higher later. Employees at a startup that launched a year ago may be able to exercise their employee stock options when there is very little spread and pay very little in taxes. Employees that wait to exercise their employee stock options until their company has an IPO may have a larger spread and may pay more in taxes.
Note: Considerations 2 and 3 are in direct opposition to one another.
Employee stock options provide employees a financial mechanism to participate in the success of their employer. It’s in everyone’s best interest that employees understand as much about them as possible. Total rewards professionals should seek educational sources that have expertise in the subject and are free from conflicts of interest.