Employee stock options are a powerful tool for businesses to provide an incentive for key employees and those who contribute to a company’s success. Stock options give you the right to purchase shares of stock at a predetermined price within a certain period of time through a vehicle called a stock option grant.
If the stock price increases above the exercise price of the stock options, the price you can buy your shares, you can profit when you exercise your option and sell your shares.
This optionality has the potential to be a lucrative source of compensation and an important topic to understand more fully.
What are the Two Types of Stock Options?
There are two types of stock options– incentive stock options (ISOs) and non-qualified stock options (NQSOs). Both types can help create a sense of ownership and commitment to the company, which can help both the company and the recipient. While similar, there are some notable differences between the two.
Incentive stock options can only be awarded to employees and only up to certain limits. They have the advantage of potentially preferential tax treatment should you meet certain holding period requirements.
Non-qualified stock options have the unique advantage of being able to be awarded to both employees and non-employees. This allows a company to compensate directors, contractors, suppliers, consultants, lawyers, and others for services rendered or as recognition for their dedication to the company.
There are several key terms of incentive and non-qualified stock option that are helpful to know:
- Grant date: the date when you are given the option to buy the stock.
- Exercise price: the price at which you can exercise your option and buy the stock.
- Expiration date: the latest date when you can exercise your options from the option grant. If you don’t exercise the options by that date, they “expire” and are no longer valid.
- Vesting Schedule: this schedule details when you obtain the right to sell your shares and how fast you can do so. In most cases, until the shares are vested, you cannot exercise your right to buy them.
- Bargain element: sometimes called the “compensation element”, this is the profit you make on the exercise of the options, determined by the difference between the option’s exercise price and the current market price of the stock when you exercise the stock options.
The type of employee stock option you have determines how the bargain element may be taxed when you exercise your stock options. If you have non-qualified stock options, the bargain element is typically taxed as ordinary income, similar to your regular wage income.
If you have incentive stock options, the bargain element may be taxed several ways depending on the timing of when you exercise your option and when you sell your shares. If you have incentive stock options, you may also need to address the Alternative Minimum Tax (AMT).
The potential tax benefit of an incentive stock option can be seen as an advantage ISOs have over non-qualified stock options. However, both types have several common advantages over other equity types that show how powerful and lucrative they may be as a compensation tool.
Advantage 1. You Have Control Regarding When to Exercise Your Stock Options
As mentioned, you receive employee stock options through a stock option grant that gives you the right to purchase a certain number of shares at a predetermined price. In some cases, you cannot immediately exercise the stock option once you receive it.
The timing of when you can exercise and sell or exercise and hold your options is typically based on what’s called the “vesting schedule.”
Until your shares vest, you cannot sell your shares. Once they do vest, however, you can act upon your ability to exercise and sell the shares, if you wish. If you want to sell your shares, you’ll want to be aware that you are not in a “blackout period” that may limit your ability to sell your shares. If you are subject to a blackout period, you’ll likely need to wait until an “open-window” to sell your shares.
Alternatively, if you believe the company’s stock will continue to rise, you can hold the options and exercise them at a later date. As long as the current stock price is higher than the option price, there is a potential to profit.
Either way, an advantage of a stock option over some other types of equity compensation is that you have control regarding the exercise of your option shares. Control may help you manage income tax, investment risk, and other financial planning goals and objectives.
Advantage 2. You May Not Need Any Cash to Exercise Your Shares
When you exercise your stock options, you have to purchase the stock at the exercise price of the option. Once exercised, you can either keep the shares or sell them and benefit from the proceeds of the transaction.
An attractive feature of employee stock options is that there may be a way to exercise your options that do not require any out-of-pocket expenses. Some of these no out of pocket exercise strategies are a sell-to-cover and a same-day sale.
Let’s explore these and other methods for exercise your options:
- First, you may consider a cash exercise. With a cash exercise, you use your cash to buy the shares at the exercise price, then recoup your cash outlay when you sell your shares (assuming you sell the shares for a price that exceeds your exercise price).
- If you aren’t in a position to use cash, you can use a sell-to-cover, method. Most times, this process is conducted through a brokerage firm. With a sell-to-cover, the firm covers the cost of exercising the stock options by immediately selling the set number of shares required to cover the cost of purchase (and possibly income tax). After completing the sell to cover, you are left owning a share amount equal to the full amount exercised less the shares sold to cover the expenses.
- Share withholding looks and feels similar to a sell-to-cover. The difference is that in lieu of using a brokerage firm to sell shares, your company will withhold the requisite shares to cover the cost, depositing the remainder into your investment account.
- A same day sale is one that exercises the option and sells all the shares on the same day. The difference between the exercise price of the option and the final sales price is the profit and is commonly deposited into your brokerage account.
- Finally, there is the stock swap method, for use if you already own shares of the company stock. You can transfer enough stock to the brokerage firm to cover the cost of the options, and they will use the value of those shares to exercise the option.
If you implement a sell-to-cover, share withholding, a same day sale, or a stock swap to exercise your employee stock options, it’s possible that you will not need to bring any cash to the table. This flexibility is attractive for someone who may not have adequate cash on hand or may not want to use that cash to buy shares of stock.
Advantage 3. You Get to Participate in the Potential Upside of the Company
Employee stock options can provide a quality source of income in addition to cash compensation. If a company prospers and the stock price rises, you share in the company’s success, and your hard work is rewarded in a tangible way. For both employees and non-employees, this is a particularly powerful compensation tool.
One main advantage of employee stock options is the potential for upside on an appreciating stock price with no added cost. As a recipient of options, you have not paid for the shares. You were given them as part of a compensation package.
Because you did not pay for options and you can benefit from an appreciating stock price, there is an argument that there is no risk to you from a financial standpoint. The higher the growth of the stock price, the more your ability to leverage the stock option for a more significant wealth generation.
However, this upside potential should continue to be managed as part of a financial plan. As the stock price increases above the exercise price, you’ll likely want to review your stock options planning and decide if and when it may make sense to exercise and sell some of your shares. Just as a stock price can increase and generate wealth, the stock price can also go down and decrease wealth too.
Advantage 4. Some or All of the Taxes May Be Taken Care of For You
If you have non-qualified stock options, the bargain element is typically reported on your form W-2 at year-end (for employees). In many cases, income tax is withheld when you exercise your options via a sell-to-cover or a same day sale. This withholding feature is a convenient way to process a tax payment to the US government. However, it’s important to know that the amount withheld at exercise may or may not be enough to cover your entire tax liability, and you might want to consider additional tax planning.
If you have incentive stock options, income tax is not withheld when you exercise your option nor when you sell your shares. This non-withholding puts more of the onus on the taxpayer to plan for a pending tax bill. Therefore, prior to acting on your incentive stock options, you may want to plan for what type of tax you may owe, how big you expect that tax bill to be, and where that money will come from.
There are many advantages to incentive and non-qualified stock options for both individuals and companies. Because of the complexities of managing employee stock option programs, as well as the various tax implications for option recipients, it’s important to work with a professional to maximize your return and take full advantage of this powerful compensation tool.
The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment. Diversification does not guarantee a profit or protect against a loss. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Tax services are not offered through, or supervised by, The Lincoln Investment Companies.