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Daily Capital

Stock Options: What Are They and How Do They Work?

How to Avoid a $150 Million Mistake

When Pinterest went public last year, many of their employees came into huge windfalls thanks to their stock options. At the time of the IPO, Pinterest CEO Ben Silbermann was purported to be worth $1.6 billion. However, if he had been a little savvier about how he handled his options, he could have walked away with around an extra $150 million. In 2013, it was reported that Silbermann was granted 31.2 million options, but according to Pinterest’s S-1, they remain unexercised. This means that he will likely face short-term capital gains tax (which could be as high as 45% — ouch!) rather than long-term capital gains had he exercised them at the right time.

Needless to say — it’s important to understand the ins and outs of how stock options work in order to maximize your potential gains.

Let’s Start With the Basics – What Are Stock Options?

Stock options are probably the most well-known form of equity compensation. A stock option is the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise” or “strike price,” for a fixed period of time, usually following a predetermined waiting period, called the “vesting period.” Most vesting periods span follow three to five years, with a certain percentage of options vesting (which means you’ve “earned” your shares, though you still need to exercise (i.e., purchase them).

When it comes to options, one of their biggest advantages is leverage. With more options per grant relative to other forms of equity compensation, there is significant upside potential But despite the upside, these don’t come without risk.

Do you have enough in your 401k to retire when you want?

How Do Stock Options Work?

Stock options are commonly used to attract prospective employees and to retain current employees.

The incentive of stock options to a prospective employee is the possibility of owning stock of the company at a discounted rate compared to buying the stock on the open market.

The retention of employees who have been granted stock options occurs through a technique called vesting. Vesting helps employers encourage employees to stay through the vesting period to obtain the shares granted to them. Your options don’t belong to you until you have met the requirements of the vesting schedule.

For example, assume you have been granted 10,000 shares with a four-year vesting schedule at 2,500 shares at the end of each year. This means you have to stay for at least one full year in order to exercise the first 2,500 shares and must stay to the end of the fourth year to be able to exercise all 10,000 shares. In order to receive your full grant, you will likely have to stay with your company the full vesting period.

Read More: How to Negotiate Your Equity Compensation

Exercising and Selling Stock Options

First and foremost, you cannot exercise your options until they are vested.

There may be some agreements that can accelerate the vesting schedule (e.g., in the event of an acquisition), but these are rare. And there are also time limits on when you can exercise or access your options – they typically expire after 10 years from the date of grant. In addition, if you are laid off before you are vested in your options or your company is acquired by another company, you may lose your unvested options.

How to Exercise Stock Options

Once you are ready to exercise your options, you typically have several ways of doing so:

  1. Cash Payment – You can come up with the cash to exercise the options. This would include covering any costs to acquire the stock.
  2. Cashless Exercise – Some employers allow you to exercise your options and your employer sells just enough of the stock to cover the costs you incurred to acquire the stock.
  3. You can sell all the shares you exercise at the going market price, which means you won’t have any ongoing exposure to any stock price volatility and you won’t have to come up with the upfront cash for any transaction costs when you exercise. However, the tax implications may not be beneficial, depending on your unique situation.

How to Calculate What Your Stock Options Might Be Worth

There is a relatively simple way to determine what your stock options are worth: if the stock is worth $25/share, and your strike price is $20, then your options will be worth $5 each.

If your company is pre-IPO, it can be difficult to figure out exactly what your stock options might be worth. How much your options could be worth in the future depends on two things: the strike price, and future performance of the stock (what will the stock be worth per share when the company goes public or there is an acquisition event, and beyond?).

Another important thing to note when evaluating the value of your options — options have little value unless the market value is greater than the exercise price, which creates a bit more risk than other forms of equity. If you exercise your options and the price decreases, then you lose both the money you’ve used to exercise the shares as well as any associated taxes.

How Are Stock Options Taxed?

There are two types of stock options – ISOs (Incentive Stock Options) and NSOs (non-qualifies or nonstatutory stock options). The main difference is how they are taxed. With NSOs, you incur a tax bill when you exercise your options. The difference between the fair market value (FMV) and the exercise price is subject to regular income tax for the year. When you sell the shares, any additional gain is taxed at long-term capital gains.

ISOs, on the other hand, aren’t taxed right at exercise. Instead, you’re taxed on ISOs when you eventually sell your shares. However, to qualify for the treatment as capital gains tax on a standard tax return, you must hold the shares two years from grant and one year from exercise (if you don’t meet this requirement, then the sale will be treated as a disqualifying disposition). If these dates are met and the value of the stock increases, you’ll only owe long-term capital gains tax when you sell.

Keep in mind — tax treatment of options can be complex, and how and when you decide to exercise and sell will be highly dependent on your unique situation. Contact your financial advisor or tax professional for specific guidance.

Read More: The Pros and Cons of Hiring a Tax Professional

Our Take

As with any form of employee equity compensation, it’s important to have a holistic understanding of what your stock options are worth and how they fit into your diversified portfolio. You’re putting yourself into a bit of a speculative position when it comes to stock options, so we usually recommend that clients work closely with their financial advisor when evaluating their strategies with stock options.

Read More: A Full Guide to Employee Equity Compensation

Disclaimer: The information and content provided herein is general in nature and is for informational purposes only. It is not intended and should not be construed as a specific recommendation, or legal, tax or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professional to help answer questions about specific situations or needs prior to taking action based on this information. Tax laws and authorities are subject to change, either prospectively or retroactively, and any subsequent change could have a material impact on your situation.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

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