Receiving stock options can provide you with a fantastic opportunity to build wealth. But as with any investment, nothing is guaranteed — and making the wrong stock option decisions could cost you.
To help you avoid making a mistake, let’s discuss the things you should consider before you do anything with yours.
What Are Stock Options?
Before you can make a good decision, you have to have a good understanding of what you’re working with — and many employees don’t fully get how these assets work.
A stock option gives you the right to buy a set number of shares of your employer’s stock at a certain price. But there a few conditions that can apply to this opportunity.
You may have to hold the options for a period before you can exercise them. This is called a vesting period.
Once you can exercise your options, you pay what’s called a strike price. This price is laid out in your original grant agreement and doesn’t change, even if the price of the stock changes.
There’s also an “expiration date” on your options. You’ll get a certain amount of time once your options vest to exercise them. An average period is 10 years — but if you leave the company for any reason, that period will likely be shortened, usually down to a number of months.
There are a couple of different types of stock options, as well as some similar benefits you may receive. Here’s how each breaks down.
Incentive Stock Options, or ISOs
This is a type of stock option that comes with a tax benefit. Instead of paying ordinary income tax when you exercise, taxes are deferred until you sell. This makes it possible to hold shares after exercise and only pay capital gains when you sell.
To get that special tax treatment, you have to hold the shares for longer than two years from the grant date and one year from the exercise date.
Beware. Exercising too many ISOs can trigger the alternative minimum tax (AMT).
This type of stock option doesn’t offer any special tax treatment.
When you exercise your options, you’ll pay ordinary income tax on the difference between the strike price and the current market value of the stock.
Restricted Stock Unit (RSU)
These are shares of common stock that are subject to vesting—the schedule may be based on performance or length of time with the employer—and other restrictions.
Once the shares are vested, you receive them immediately. You pay ordinary income tax on the full value of the shares at vest.
Understanding Employee Stock Purchase Plan, or ESPPs
ESPPs allow employees to purchase shares of the company’s stock at a discount.
You’ll typically contribute money to the plan through payroll until the designated purchase date, at which point the company purchases shares on behalf of the employee with the money that’s built up.
We work with a lot of Salesforce employees. Their ESPP is really great, and Salesforce offers some great videos that explain all the benefits of an ESPP.
Some companies, like Netflix, offer a unique stock option plan to its employees.
With the Netflix employee stock purchase plan, in addition to an annual grant of options on top of their salary, employees can also elect to receive part of their salary in the form of options instead of cash.
The Netflix stock purchase plan is similar to an ESPP because you can choose to increase or decrease your participation. You set your participation rate. The money you contribute is used to purchase nonqualified stock options (NQs) that vest immediately.
How to Make Good Stock Option Decisions
You can go through this decision workflow to get to a smart choice for you.
Ask yourself these three questions. Follow your answers (either yes or no) to reach a good decision on how to handle your stock options.
1. Do You Believe in the Company?
If your answer is no, look to sell as soon as possible. Taxes are less of a concern in this case because of the prospect of losing even more money if the company tanks, and you waited to sell.
If, however, you do believe in the company, how strong is your belief? For example, if you think you work for the next Apple, you don’t want to sell too early.
It’s important to consider how much untapped potential is in the company. A company like Google, Facebook, or Apple may not have much untapped potential left.
Here is a great chart showing the five most valuable stocks in 2001, 2006, 2011, and 2016. Notice how few companies stay in the top five over time.
In contrast, companies like Uber, Lyft, Pinterest, Dropbox, Airbnb, or the startup you work for might have a lot of room left to run.
Depending on the company and your grant agreement, however, you may have to wait a while anyway before you can make any moves.
2. Do You Have Money Needs That Are More Important Than the Company’s Bright Future?
Selling now could make more sense than banking on what you hope happens with the company in the future, as long as you make smart use of that money today.
If you’re buried under student loan debt, need some cash for a house down payment, or want to fund big parts of your financial plan that will set you up well for the future no matter what happens to the company — then it might be a good idea to sell.
We all have different financial goals and needs, so it’s critical that you evaluate your financial situation to determine if this is important. A fee-only financial planner can help you accomplish this.
3. How’s Your Tolerance for Risk?
What would you do if your account showed $2 million one day — and then in a few months was down to $500,000? Your answer to that question should give you an idea of your risk tolerance.
As another example, let’s go back to Netflix to see the kind of changes its stock experienced over the last 10 years. Imagine that you are a Netflix employee with 50,000 stock options.
- In October 2008, Netflix stock was $2.70 per share. Your options are worth $135,000.
- By July 2011, $42.16 a share. Your options are worth $2,108,000.
- In August 2012, Netflix stock was down to $7.70 a share. You log into your account, and the number on the screen has fallen to $385,000. In one year, you lost $1,723,000.
- By October 2017, Netflix stock was up to $194.16 a share. Your 50,000 stock options are worth $9,708,000.
Imagine if you had held on to your Netflix stock options for 9 years. You would have had quite the ride, but your willingness to stay calm and stay the course would have paid off in a big way.
You have to be prepared to hold steady through the ups and downs, regardless of how much risk you think you can handle today. This process will test your emotions, so know yourself and make sure you can weather the storm.
Again, this is where it might help to have a financial advisor, who knows tech and stock options, on your side.
You Believe in the Company and Want to Hang in There. Now What?
If your belief is still strong, don’t sell. Instead, you’ll want to delay your exercise strategically to minimize your tax burden.
Again, this will differ depending on the type of options you have. With ISOs, you need to hold the shares longer than two years from the grant date and one year from the exercise date to qualify for the capital gains tax rate.
With NQs, on the other hand, wait until closer to expiration or until the current market value of the stock reaches a price at which you are willing to sell. That way, the actual gains can offset the taxes.
If your employer offers an ESPP, maximize your participation in it. You won’t get your company’s stock at a discount anywhere else.
Hey, Netflix Employees: This Note on Stock Options Is for You
The Netflix stock option plan is unlike any other. With such a robust stock option plan, it’s crucial that you time your participation correctly.
Identify a targeted price that you’ll act on without question. When Netflix stock trades below your targeted price, you hold the options you have, exercise options that are about to expire, and increase your participation in the stock option plan.
But when Netflix stock trades above your targeted price, you sell based on your tax plan and lower your participation rate.
The Bottom Line with Stock Option Decisions
Whatever type of stock option plan your company offers, be proactive about how you’ll take advantage of it. Bad stock option decisions could result in substantial losses.
But having a plan can help you make good stock option decisions and put money in your pocket. Make sure you’re prepared to make the best decisions possible for you and your goals.