Stock options are a form of equity compensation that technology companies often offer to their employees. Stock options give employees the right, but not the obligation, to buy a certain number of company shares at a predetermined price, known as the “strike price” or “exercise price,” within a specified time period, known as the “vesting period” or “exercise window.”
Two main types of employee stock options:
Incentive Stock Options (ISOs): ISOs are qualified stock options that are eligible for special tax treatment under the U.S. tax code. They are typically offered to executives and key employees and may have more favorable tax treatment compared to other types of stock options. To qualify for the special tax treatment, ISOs must meet certain criteria, such as holding periods and exercise price limitations. If the requirements are met, employees may be subject to long-term capital gains tax rates upon selling the stock, which are generally lower than ordinary income tax rates.
Non-Qualified Stock Options (NSOs): NSOs are stock options that do not qualify for the special tax treatment of ISOs. They are typically offered to a broader range of employees and do not have the same tax advantages as ISOs. When NSOs are exercised, the difference between the fair market value of the stock at the time of exercise and the strike price is treated as ordinary income, and employees are subject to ordinary income tax rates on that amount. Any subsequent gain or loss upon selling the stock is treated as a capital gain or loss.
It’s important to note that the specific terms and conditions of stock options, including vesting schedules, exercise prices, and tax treatment, can vary depending on the company’s stock option plan, as well as the individual’s employment agreement. It’s crucial for employees to carefully review and understand the details of their stock option grants and consult with qualified financial and tax professionals for personalized guidance.
This article will focus on NSOs, although many of the concepts apply to both types. Read THE DIFFERENCE: ISOs VS. NSOs EQUITY COMPENSATION for more details.
What does “strike price” mean for employee stock options?
The “strike price” or “exercise price” is a predetermined price at which an employee is granted the right to buy a certain number of company shares when exercising stock options. It is the price at which the employee can purchase the company’s stock, subject to the terms and conditions of the stock option grant.
The strike price is set when the stock options are granted and typically reflects the fair market value (FMV) of the company’s stock at that time. For private (or pre-IPO) companies, the FMV is usually determined by the company’s board of directors or a third-party valuation, and it may be adjusted in certain circumstances, such as during a stock split or merger.
When an employee chooses to exercise their stock options, they pay the strike price per share to the company, and in return, they receive the corresponding number of company shares. The hope is that the stock price will have appreciated since the grant date, allowing the employee to buy the stock at a lower strike price and then sell it at a higher market price, resulting in a profit.
The difference between the fair market value of the stock at the time of exercise and the strike price is called the “spread.” This spread is subject to ordinary income tax (for non-qualified stock options) when the option is exercised.
What does “vesting period” mean for employee stock options?
Vesting Period: The vesting period is the length of time that an employee must work for a company in order to earn the right to exercise or purchase stock options. Stock options typically have a vesting schedule, which outlines the specific timeline or milestones over which the options become “vested” or “earned.” Until the options have vested, the employee does not have the right to exercise or purchase them.
Vesting schedules can vary depending on the company’s stock option plan and the terms of the individual stock option grant. Common vesting schedules include “cliff” vesting, where the options vest all at once after a certain period of time, and “graded” or “graded vesting,” where the options vest gradually over a period of time, such as monthly or annually, until they are fully vested. For example, a stock option grant with a cliff vesting period of four years means that the employee would need to work for the company for four years before any portion of the options become vested and exercisable.
What does “exercise window” mean for employee stock options?
Exercise Window: The exercise window, also known as the “exercise period” or “exercise timeframe,” is the duration during which an employee can choose to exercise or purchase their vested stock options. Once stock options have vested, the employee typically has a limited period of time, known as the exercise window, within which they can choose to exercise the options and purchase the company’s stock at the predetermined strike price.
The exercise window is determined by the company’s stock option plan and is outlined in the individual stock option grant. It can vary in length, but it is often several years, typically ranging from 30 days to 10 years after the options have vested. It’s crucial for employees to be aware of and understand the exercise window for their stock options, as it represents the timeframe during which they have the opportunity to exercise and potentially realize the benefits of their stock options.
It’s important to note that if an employee does not exercise their vested stock options within the specified exercise window, the options may expire and no longer be exercisable. Therefore, it’s essential for employees to carefully track and manage their stock options, including understanding the vesting period and exercise window, in order to make informed decisions about when and how to exercise their options.
Are stock options better than RSUs for tech employees?
Whether employee stock options or restricted stock units (RSUs) are better depends on various factors, including an individual’s financial situation, investment goals, risk tolerance, and personal preferences.
Here are some key points to consider for each:
Employee Stock Options:
Potential for higher returns: employee stock options give employees the right to buy company stock at a predetermined strike price, which can potentially result in higher returns if the stock price increases significantly above the strike price.
Flexibility in timing: employee stock options typically have an exercise window during which employees can choose when to exercise the options, providing flexibility in timing to potentially optimize tax implications.
Higher risk: employee stock options are dependent on the company’s stock performance and can become worthless if the stock price does not exceed the strike price during the exercise window.
May require upfront cost: Employees may need to pay the exercise price upfront to buy the stock when exercising employee stock options, which can require significant cash outlay. Although at least for public companies, it is usually possible to do a cost-less exercise. Basically, sufficient shares are sold to cover the cost of exercising the options and the employee retains the remaining shares.
Restricted Stock Units (RSUs):
“Guaranteed” value: RSUs are usually granted as a certain number of company shares that vest over time, and the value of RSUs is based on the company’s stock price at the time of vesting. As long as the RSUs vest, they typically have some value.
No upfront cost: RSUs do not require employees to pay an exercise price or buy the stock, as they are usually granted as shares outright.
Lower risk: RSUs have less risk compared to NSOs, as the value of RSUs is not dependent on the stock price exceeding a strike price. Even if the stock price does not increase significantly, employees will still receive the vested RSUs.
Less flexibility in timing: RSUs typically vest over time, and once they vest, create a taxable event.
Ultimately, the value of NSOs vs. RSUs depends on an individual’s financial goals, risk tolerance, and personal circumstances.
How Should I Value my NSOs?
Valuing non-qualified stock options (NSOs) can be complex and typically requires consideration of various factors, including the current stock price, exercise price, time remaining until expiration, volatility of the underlying stock, and prevailing interest rates.
Here are some data points that should considered when valuing NSOs:
Current stock price: The current market price of the underlying stock is obviously an important factor in valuing NSOs. This information is usually readily available from stock exchanges or financial websites.
Exercise price: Also known as the strike price, is the price at which the NSOs can be exercised to buy the stock. It is usually set at the grant date and is specified in the stock option agreement.
Calculate the intrinsic value: The intrinsic value of NSOs is the difference between the current stock price and the exercise price. If the current stock price is higher than the exercise price, the NSOs are considered to have intrinsic value.
Consider time remaining until expiration: NSOs have an expiration date, after which they are no longer valid. The time remaining until expiration is a factor in valuing NSOs, as options with more time until expiration typically have higher value compared to options with less time remaining.
Account for stock price volatility: Higher stock price volatility can increase the value of NSOs, as it provides more potential for the stock price to move above the exercise price. Historical stock price volatility or implied volatility, which is a market-based estimate of future stock price volatility, can be used as a reference in valuing NSOs.
Consider prevailing interest rates: Prevailing interest rates, such as risk-free rates, can also impact the value of NSOs. Higher interest rates may reduce the present value of the potential stock appreciation from exercising NSOs, while lower interest rates may increase the value of NSOs.
It’s important to note that NSO valuation can be subjective and may require professional expertise, such as from a financial advisor, tax professional, or valuation expert. The specific valuation method and assumptions used may vary depending on the circumstances.
You can also look to the public markets. If you work for a large tech company, there may be stock options traded on your company. Although the public markets might give you an idea of value, NSO are different from publicly traded options and should be valued differently.
Here are a couple of calculators to help value your options:
How are NSO Different from Options I Could Buy from a Brokerage Firm?
Non-qualified stock options (NSOs), which are typically issued by employers as part of employee compensation, differ from stock options that can be bought from a brokerage firm in several key ways:
Source of options: NSOs are typically granted by an employer as part of an employee’s compensation package, while stock options purchased from a brokerage firm are typically traded on a public stock exchange and acquired by an individual investor in the open market.
Exercise price: NSOs have a predetermined exercise price, also known as the strike price, which is typically set at the grant date and specified in the stock option agreement. The exercise price determines the price at which the employee can buy the company stock when exercising the NSOs. In contrast, stock options purchased from a brokerage firm in the open market can have a wide range of strike prices and expiration dates.
Tax treatment: NSOs are subject to different tax treatment compared to stock options purchased from a brokerage firm. When NSOs are exercised, the difference between the exercise price and the fair market value of the stock at the time of exercise is generally considered ordinary income and subject to income tax and potentially other taxes. In contrast, the tax treatment of stock options purchased from a brokerage firm depends on various factors, such as the holding period of the option.
Vesting and restrictions: NSOs are often subject to vesting and other restrictions as part of an employee’s overall compensation package. Vesting refers to the process by which NSOs become exercisable over time, usually according to a predetermined schedule. In contrast, stock options purchased from a brokerage firm do not typically have vesting or other restrictions, as they are acquired by the individual investor in the open market and are immediately exercisable.
Employer affiliation: NSOs are issued by an employer, and their exercise and sale are typically subject to the employer’s policies, procedures, and rules. Stock options purchased from a brokerage firm, on the other hand, are not tied to any specific employer and are subject to general market rules and regulations.
Expiration date: often NSO have expiration dates many years after vesting. Whereas, publicly traded options generally are for shorter periods of time. Although, for some companies, there are long-term options traded.
It’s important to understand these key differences between NSOs and stock options purchased from a brokerage firm, as they can impact the terms, conditions, and tax treatment associated with each type of option.
How Many Options Should I Expect When Hired?
The number of stock options a new employee can expect to receive when hired at a tech company can vary widely depending on various factors, such as the size and stage of the company, industry norms, and the individual’s level of experience and negotiation skills. Generally, stock options are used as a form of equity compensation to attract and retain employees, particularly in the technology industry where stock options are commonly offered.
The specific number of stock options granted to a new coder or developer will typically be outlined in the offer letter or employment contract, and it may be expressed as a specific number of shares or as a percentage of the company’s total equity. It’s important for the employee to carefully review and understand the terms and conditions associated with the stock options, including the vesting period, exercise price, and any other restrictions or requirements.
The number of stock options granted can vary widely depending on the company’s size and stage of development. For example, larger and more established technology companies may offer higher numbers of stock options, while smaller or early-stage startups may offer lower numbers of stock options due to limited resources or higher risk associated with the company’s stage of development. In some cases, stock options may be part of a larger equity compensation package that includes other forms of equity, such as restricted stock units (RSUs) or performance-based stock awards.
It’s important for employees to carefully evaluate the value of stock options in relation to their overall compensation package, taking into consideration factors such as the company’s growth potential, the stock’s expected future value, and the individual’s personal financial goals and risk tolerance.
How Do Employee Stock Options for Pre-IPO Companies Differ?
Stock options offered by a public technology company and a pre-IPO (Initial Public Offering) company can have different characteristics and considerations due to the varying stages of the companies’ development and the nature of their stock.
Liquidity: Stock options in a public technology company are generally more liquid compared to stock options in a pre-IPO company. Public company stock options can typically be exercised and sold on a public stock exchange, providing employees with more flexibility in realizing the value of their options. On the other hand, stock options in a pre-IPO company may have restrictions on exercise and sale due to the lack of a public market for the company’s stock, which can limit liquidity.
Valuation: Valuing stock options in a public technology company is typically based on the current market price of the company’s stock, which is publicly traded and subject to market forces. In contrast, valuing stock options in a pre-IPO company can be more challenging as the company’s stock is not publicly traded and its value may be based on internal or external valuations, which can be more subjective and uncertain.
Risks: Both public technology companies and pre-IPO companies come with their own risks. Public technology companies may be subject to market volatility, regulatory changes, and other external factors that can impact the value of their stock options. Pre-IPO companies, on the other hand, may have higher risks associated with their stage of development, such as uncertainties around the company’s future prospects, market competition, funding, and the timing and success of an eventual IPO.
Exit Strategies: Public technology companies offer the ability to sell the stock on a public stock exchange. In contrast, pre-IPO companies may have limited exit strategies, as the stock is not publicly traded, and employees may need to wait until the company goes public or is acquired to realize the value of their stock options.
Tax Considerations: Tax implications can also differ between stock options in public technology companies and pre-IPO companies. Tax treatment for stock options can vary depending on the jurisdiction, the type of options (e.g., NSOs, ISOs), and other factors. It’s important to understand the tax implications associated with stock options in both public technology companies and pre-IPO companies, including the timing of taxes upon exercise, sale, or other events.
It’s crucial to carefully review and understand the terms and conditions of stock options offered by both public technology companies and pre-IPO companies, including the vesting period, exercise price, potential risks, tax considerations, and liquidity options.
When Should I Exercise My NSOs?
The decision of when to exercise non-qualified stock options (NSOs) is dependent on various factors, including your personal financial situation, investment goals, risk tolerance, and the specific terms and conditions of your NSO agreement. Here are some considerations to keep in mind:
Tax Implications: Exercising NSOs typically triggers ordinary income tax on the difference between the fair market value (FMV) of the stock at the time of exercise and the exercise price. If you exercise NSOs as soon as they vest, you may need to pay taxes on the gain at that time, which can impact your current cash flow and tax liability. However, waiting until just prior to the expiration date may delay the tax impact but also carries the risk of potential changes in the stock price and tax rates.
Stock Price Outlook: If you believe that the stock price of the company will appreciate further after the NSOs vest, you may consider waiting to exercise the NSOs to capture potential future gains. However, if you have a negative outlook on the stock price or if the stock price is close to or below the exercise price, you may consider exercising the NSOs sooner to avoid potential losses or expiration of the options.
Cash Flow and Financial Needs: Exercise of NSOs requires paying the exercise price, which may require cash or other means of funding (if your company is still private). If you do not have sufficient liquidity to exercise the options, waiting until just prior to the expiration date may give you more time to arrange for necessary funds. On the other hand, if you have the necessary funds to exercise the options and the stock price is favorable, you may consider exercising the NSOs earlier to lock in potential gains.
Company and Market Risks: The stock price of the company and market conditions can be volatile and may impact the value of NSOs. Waiting until just prior to the expiration date may expose you to the risk of potential stock price declines, which can reduce the value of the NSOs. On the other hand, exercising the NSOs as soon as they vest may allow you to capture gains early but also expose you to potential losses if the stock price declines after exercise (assuming you continue to hold the stock).
Expiration Date: NSOs have a specific expiration date, after which they become worthless. Waiting until just prior to the expiration date may increase the risk of missing the deadline to exercise the options, which can result in a complete loss of value. It’s important to be aware of the expiration date and consider it in your decision-making process.
In summary, the decision of when to exercise NSOs depends on various factors, including tax implications, stock price outlook, cash flow and financial needs, company and market risks, and the expiration date of the options. It’s recommended to carefully review your NSO agreement, assess your individual financial situation and goals, and seek professional advice from a qualified financial advisor or tax professional before making any decisions.
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