Employee stock options let you own a little piece of the company, so that you profit when your company profits. Understanding the ins and outs of options helps you make the most of this benefit.
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Employee stock options are call options, which give the employee the right (but not the obligation) to buy the stock at a particular price -- known as the strike or exercise price. The call option can be compared to a deposit, as the contract allows the employee to complete a transaction to buy stocks at the exercise price. If the stock value rises higher than the exercise price, you can buy the stock, and then resell at the higher value. Ideally, employee stock options would motivate employees to work toward increasing the company's profits. On the other hand, employee stock options also allow employers to give incentives to employees without necessarily paying compensation up-front.
Employee stock options may push employees to stay with the company, says Jon W. Ulin, managing principal of Ulin Financial Group, which provides on-site coaching and workplace financial education programs addressing employee stock options.
"Though the options could be worth zilch -- or potentially up to 100% or more of the employee's negotiated salary -- there are specific restrictions to own or exercise (purchase) the stock options," explains Ulin.
Employee stock options have an expiration date, and once the expiration date passes, the options are no longer valid. The time to expiration is also known as the option's time value, which is a value it has in addition to the intrinsic value of the stock.
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Types of employee stock options
Stock options have different classifications depending on how they are taxed.
Incentive stock options (ISOs) provide important tax benefits. ISOs allow you avoid paying income tax when you exercise, as long as you hold the shares for at least one year from the date of exercise and two years from when the options were granted. While exempt from income tax, you would pay a long-term capital gains tax after you sell the shares. Long-term capital gains tax rates are typically more favorable than income tax rates. According to Ulin, highly-compensated employees are more likely to receive ISOs.
Nonqualified stock options (NSOs) do not confer tax benefits, so you will be subject to income taxes on the difference between fair market value and the exercise price. You will also be subject to income tax and capital gains taxes once you sell the stocks.
Exercising your options
Exercising your stock options simply means taking up the offer to buy the stocks at the stated price. You may have several options for exercising, or you can hold your options without exercising up until they expire. (Keep in mind that holding gives the stocks time to appreciate, but you lose time value as the option approaches expiration.)
You can exercise your stock options with cash by simply buying the shares at the exercise price. If you do not wish to pay cash for the shares, you may be able to opt for a cashless transaction, which Ulin describes as the most common method to exercising stock options. Cashless transactions allow you to buy shares of your company stock by taking out a loan from a stockbroker.
You can also exercise your options with a stock swap, which allows you to swap company stock that you already own. This way, you can essentially trade in a certain amount of stock for more shares, since the option allows you to buy shares at a lower price.
Vesting is a restriction on employee stock options, and the vesting period usually limits when an employee can exercise the options. During this time period, stock options will typically accrue annually until reaching the full amount of shares. In other words, if your employee stock options account for 1,200 shares, vesting may grant you 300 shares a year for four years. As such, vesting compels you to hold onto your stock options for a minimum amount of time before exercising.