Understanding Your Employee Stock Options

Maybe your employer offers stock options, or maybe you just aspire to a job that has them. If you plan on tangling with employee stock options in hopes of living like the next Google stock option millionaire, there are some basics you need to know. Let's start with what an employee stock option actually is. Employee stock options (ESO's) give you the right to buy stock in the company you work for at a price that your employer has set in advance. Notice that this does not mean you're given the stock for free! If you are deciding whether and when to buy those shares, start with these tips:

First, find your Stock Option Plan Agreement.

This is the contract between you and your employer that lays out all of the terms for when, where and how you can exercise your options and sell your stock. If you are looking at your agreement and find that what you've got is Restricted Stock, stop here. Restricted Stock Units (RSU's) are an increasingly popular alternative to the old stock options, but they are a completely different beast and will get their own post. If you do have a Stock Option Plan, then...

Look for the vesting period.

When an employee chooses to buy the stock offered by an ESO, we say she is "exercising her stock options." She can only do this, though, after the options have "vested." For most ESO plans, that is going to be 1-3 years after you get the options, and many plans set their options to vest gradually. For instance, 25% of your options might vest one year, the next 25% a year later, and so on. During the vesting period, the stock options are nothing more than a potential benefit of working for your company.

Make a note of the exercise price.

The exercise price is how much you would have to pay to buy the stock. The idea here is that your company is growing more valuable over time. So if shares are worth $10 a piece now, they might be worth $13 next year, $16 to following year, and so on. That price that you can get on the market for your stocks is known as the "strike price." So, in this example, if the exercise price that you paid your employer for the stock was $10 and you can now sell them in the open market for $16, you've made $3 per share. Great! Of course, the other possibility here is that your company's stock price goes down after you've bought your shares. And that's why you need to look further.

When do your options expire?

Your Option Agreement will have a time after which those options are...no longer an option. If you don't exercise them before that date, they just go away as if they'd never existed. Until that date, though, you can keep an eye on the company's stock price and keep considering whether exercising your options makes sense.

Where will you get the cash to buy your new shares?

If you are looking at options that let you buy company shares at a discount, you probably want to exercise those options, but you still need to figure out how you are going to pay for it. The simple answer is to come up with cash from your savings. Because that doesn't always sound appealing, a common arrangement is to buy on margin—meaning that you or your employer has arranged to borrow money from the brokerage house to buy the shares. The broker will take their money back when you sell your stocks. But be aware of the risks of margin trading if you plan to hold on to the stocks for a while.

Figure in the taxes.

As you've noticed, stock options don't count for anything unless you exercise them. But if you do exercise them, you have just received a form of payment from your employer. And that means paying taxes. The year in which you exercise the stocks, you will have to pay income tax on the value of those stocks (even if you don't sell them right away). We usually check with a client's accountant before giving advice on stock options just for this reason—if you are considering exercising your stock options, preparing for the extra taxes is crucial.

Know what kind of ESO you have.

Employee stock options come in three flavors. A Non-statutory ESO is the standard, and they are pretty much as I've described above. But there are twists with the other two ESO types. A "Reload ESO" just keeps shoveling more stock options into your basket as you use up the old ones. So if you exercised 25% of your options this year, the company will replace those with new options. For these new ones, though, your exercise price will be reset to this year's market value.

But your ESO may actually be an ISO, an Incentive Stock Option plan. These are designed to keep you out of trouble with taxes. And to do that they force you to hold on to your stock for a year between the time you exercise the options and sell the stock. With these you pay capital gains tax, a much lower rate than you standard income taxes. There is a downside, though—you run the risk of buying stocks only to watch their value drop during the year you have to hold them. That scenario is always disappointing, but it can be a big problem if you borrowed to cash to exercise your options.

 So, should I exercise my options? And when should I sell them?

Assuming your options worked as hoped and are worth some money, the question of whether to exercise stock options almost always comes down to taxes. Don't ever exercise a stock option until you have a good estimate of how it will affect your tax bill and whether the "hit" will be worth it.

Where most people get frustrated is in the question of how long to hold their company's stock once they have it. This, too, might be a tax question. If you have held on to your shares for a while, you will pay a capital gains tax on the amount your shares have gone up in the meantime (over and above any tax you paid on that initial exercise price).

But the bigger issue here is whether continuing to hold your employer's stock is keeping you from putting that money in investments that are better suited to your plans and sense of risk. Think of it this way: if you did not already own company stock, and I offered to sell you the same amount of shares in your company or in something else (another company, an index fund, bonds, etc...) which would you choose? If the answer is something other than your employer's stock, it's probably time to sell up.