Many companies offer their employees stock options as part of their compensation packages. Stock options offer the right to purchase shares of the company at a fixed exercise price for a specified number of years. For example, your employer may offer you options to purchase 10,000 shares of the company at a strike price of $1 that vests over four years with the first 25% vesting on your one-year anniversary. Generally, options are exercisable on or after their vesting date. However, some optionees have the opportunity to exercise options before they vest in what is called an early exercise option. This type of compensation may provide the opportunity for a significant payout in the future if the value of the stock continues to rise after the options are exercised. But option exercises also create the potential for a significant tax bill. Some people can reduce their tax liability by exercising stock options early, and we’ll discuss the benefits and risks of this strategy below.
Stock options are a common form of equity compensation, and they can be a valuable asset in your financial planning strategy. However, as with all areas of finance, it’s important to recognize that your finances and your emotions are intertwined. While you may think you make completely rational financial decisions, human nature makes it nearly impossible to do so. In the case of stock options, you may feel that your financial investment and your professional investment of time and energy are linked. This can make it difficult to make the decision to cash in – even if it’s the best financial move for you.
Below are four tips to help you separate your emotions from your financial decision-making around your stock options.
Stock options are an incredibly popular method of attracting and retaining employees, especially if a company isn’t yet able to offer high salaries. This is one reason that many start-ups are taking advantage of the flexibility a stock option plan offers, permitting their employees to share in the company’s future success – but without spending precious cash to do so.
If you were granted stock options by your company, or you’re considering an employment offer from a start-up that includes them, there are three basic things you’ll want to understand.
1. Why Is The Company Offering Stock Options?
If you’re working for a start-up or considering an offer from one, know that there are three main reasons that you might be granted stock options as part of your employee benefits package:
- The company wants to attract, motivate, and retain employees, but they lack the capital to offer more competitive salaries. (Many people have become millionaires through stock options, especially in Silicon Valley, making options a very appealing benefit to employees.)
- The promise of significant future value can make employees feel like they have a bigger stake in the company’s success, thereby making them work harder and feel more dedicated to the job.
- As a smaller company, a start-up can level the playing field a bit and compete with larger companies by offering stock options to some or all employees.
Regardless of a company’s reasons, as the employee you can benefit from this form of equity compensation because it represents the potential to share in the future growth of the company’s value – and with little risk, too, until your options are exercised. (More on that below.)
2. How Do Stock Options Work?
Here’s an example of how it works:
Company X hires employee Jane Smith. As part of her employment package, the company grants her options to acquire 40,000 shares of Company X’s stock at an exercise price equal to the fair market value of the stock at the time of grant – let’s say that’s 25 cents per share.
Jane reads the fine print and sees that her options are subject to a vesting period, which is very common. In her case, the stock options are subject to a four-year vesting with one year “cliff vesting.” This means that Jane will have to remain employed at Company X for one full year before she earns the right to exercise 10,000 (one fourth) of the options. The remainder of the options will vest at a rate if 1/36 per month over her next three years at the company. If she leaves before one year – or is fired before that time – she will not get any of the 40,000 options.
Once Jane’s options are vested, she can choose to exercise them. Essentially, this means she can now buy the stock at 25 cents per share (exercise price) even if the value of the stock has increased considerably.
Let’s say that Jane stays with Company X for the full four years needed for all 40,000 shares to vest, and the company has become very successful and gone public during that time. In fact, shares are now trading at $20 per share. Jane sees the opportunity and she exercises her options by purchasing 40,000 shares for $10,000 (40,000 shares x 25 cents per share). She then sells all 40,000 shares at their current value of $20 per share for $800,000 – a tidy profit of $790,000.
It’s easy to see why the possibility that comes along with stock options is so appealing. And with examples of massive profits for employees (think Facebook), start-ups are eager to capitalize on the popularity of stock options.
3. A Disadvantage To Be Aware Of…
Stock options can be of tremendous benefit – just look at the example of Jane above. The potential they offer might give you good reason to stick with a start-up that can’t yet offer a competitive salary.
However, there is one big disadvantage to being granted stock options in a private company, especially a start-up, and that’s the lack of liquidity. Why? Well, until the company creates a public market for its stock (e.g. IPO), is acquired, or offers to buy back employees’ options or shares, there is no way to access the cash value of the options or shares. Cash paid to exercise the options, and the intrinsic value of the options or shares is especially locked with the company until a liquidity event occurs. Sure, the company could grow bigger, and the stock could become more valuable. However, there are no guarantees and if those things don’t come to pass, then the options can prove worthless.
Want To Know More About Stock Options?
At Wade Financial Advisory, we work with many clients to provide guidance on maximizing their equity compensation benefits and fitting them into a comprehensive financial plan. In fact, we currently serve clients working for companies such as Tesla, Facebook, Nvidia, Applied Materials, Apple, Microsoft Corporation, Google, Intel, Cisco Systems, Hewlett Packard, Pure Storage, Zoom Video Communications, Amazon, Adobe Inc., Palo Alto Networks and many others.
If you need a trusted partner in making the most of your stock option benefits, let’s talk. You can schedule an introductory conversation here. We look forward to hearing from you!
At Wade Financial Advisory, our clients include successful entrepreneurs, professionals, and executives, and many of them practice philanthropy. If you’d like professional support in optimizing your charitable giving, or any other aspects of your financial plan, please reach out to us today. We currently serve clients working for companies such as Tesla, Facebook, Nvidia, Applied Materials, Apple, Microsoft Corporation, Google, Intel, Cisco Systems, Hewlett Packard, Pure Storage, Zoom Video Communications, Amazon, Adobe Inc., Palo Alto Networks and many others. We would be pleased to serve you and your family, too!
Employee stock options are a common form of equity compensation that companies use to attract and retain the best talent. Stock options give you the potential to share in the growth of your company’s value with little risk to you – until you exercise your options, that is. There are multiple types of stock compensation, and each is granted, managed, and taxed in its own way. In this article, we’ll touch on some of the differences between non-qualified stock options (NQSOs), incentive stock options (ISOs), and restricted stock so that you can maximize your stock options, guard against unfortunate tax surprises, determine who you will need to consult with, and plan accordingly.
In recent years, generating income from stock options has regained its popularity in executive compensation packages, after falling out of favor during the dot-com bust. Their recent resurgence means there are also growing numbers of executives making poor choices, often because they lack good advice or because they have unwarranted optimism about their companies’ stock prices. Making good decisions and maximizing the value of your stock options starts with understanding what you have. Then, you can begin to develop a strategy that optimizes their value by incorporating tax consequences, your personal risk appetite, the company’s outlook, and more.