The Definitive Guide to Employee Stock Options

by | Oct 10, 2017 | Stock Options

The Definitive Guide to Employee Stock Options

by | Oct 10, 2017 | Stock Options

employee stock options

Making sense of your employee stock options is tough.

A quick Google search won’t help.

Search “stock options”  You get results that include instructions on how to buy “call” or “put” options.  This is not helpful at all when you are just trying to make sense of the grant you received at work.

You will see “employee stock options” buried within those results.  This is a little more helpful but not specific to tech.

Receiving stock options working in the technology sector makes you unique.

Outside of tech, stock options go to executives.  In tech, your employee stock options will be a key part of your compensation.  You need to understand what you have.

Our work at KB Financial Advisors gives us a unique view of stock options.  Every week we review new stock option agreements.  We see what’s happening out there.

We also see new trends emerge.  Changes to how companies handle stock options generate emails and phone calls.  It’s exciting work.

The goal of this post is to help you understand your stock options.  Having a clear view of what you have and the actions you need to take can uncover hidden opportunities.

What are employee stock options?

Your stock options are the ability to buy shares of stock in the company at a certain price.  This is true for incentive stock options (ISO) and nonqualified stock options (NQSO).

Restricted Stock Units (RSU) are a promise by the company to give you shares of stock in the future.

Tech companies are organized as corporations.  This allows the company to have many owners.  Shares of stock represent ownership in the company.

Why do tech companies give stock options to employees?

There is little information on the history of stock options in tech companies.

Andy Rachleff wrote a great post for the Wealthfront Knowledge Center.  In the post, Andy gives some history on stock options in tech, and how Facebook pioneered RSU.

But, there are four reasons why tech companies give out stock options.

1. Tech Companies Want You to Think Like an Owner

There is a gap that exists in all companies with owners and employees as a separate group.  The owners in general want what is best for the company (themselves).  The employee wants what is best for themselves.

The best interests of the company and the employee are not always aligned.

Stock options help to bridge the gap.

Stock options are a way to get employees to think more like owners.  Receiving stock options ties your future wealth to the success of the company.

The founders want you to think like an owner instead of an employee.

2. Tech Companies Want to Keep You Around

One goal of granting stock options is to improve employee retention.  Stock options are used as golden handcuffs.

Your stock options will have a vesting schedule.  The company wants your options to be so valuable that you will not leave before your shares vest.

3. Stock Options Are Cheaper than Paying You Cash

Start-ups in the early stages cannot afford to pay tech talent the way Google or Apple can.  They use stock options as a way to compete.

This gives you as an employee the opportunity to decide what do you value more.  Do you want the higher salary today?  Do you want the larger potential payoff in the future?

Aesop said, “A bird in the hand is worth two in the bush.”  Warren Buffet pointed out in 1999 that the missing piece from Aesop is, “When?”

Stock options let you decide when two birds in the bush (stock options) are worth more.

Jonathan Libov did a great job writing about this:

“…this what companies do with equity options and grants to employees; if companies could not include equity in their compensation packages, they’d need to spend a lot more money, which means they’d need to raise a lot more money. Distributing equity is one way that startups manage their (anticipated) high rate of growth.”

Stock options allow start-ups to pay you less salary.  Paying you less salary means they have to raise less capital.  It also means they can operate longer on their current capital.  Stock options become a way for start-ups to borrow against their future success.

4. Because Everyone Else is Doing It

Tech companies give employees stock options and RSU because everyone else is doing it.  This is “me too” at its best (or worst).

Every other tech company does it.  Prospective employees expect it.  So they do it too.

In most cases, you would be better off if they increased your salary.

Five Types of Stock Options

Stock option is a term used to describe different types of employee stock options.

We will note that a more accurate description would be equity awards.  Not all of what we refer to here as “stock options” are actual options.  Restricted Stock Units are not an option; they are a grant of shares.

Most employees refer to all five types as stock options.  We will keep it simple and do the same.

Stock options vary based on:

– What decisions you make

– How you get taxed

There are five types of stock options we have seen at KB Financial Advisors.

1. Incentive Stock Options

Incentive stock options (ISO) feature a vesting schedule and an exercise price.  When you exercise your ISO shares, you are not taxed for ordinary income tax purposes.

You decide when to exercise and what to do with the shares afterward.

Not paying ordinary income tax at exercise is unique.  You may be in the position to exercise your shares without owing any taxes.

But, you may pay the alternative minimum tax (AMT) when you exercise.  You can recapture the AMT in future years as a tax credit.

2. Nonqualified Stock Options

Nonqualified (NQ) stock options feature a vesting schedule and an exercise price.  You pay ordinary income tax on your bargain element when you exercise NQ shares.

You decide when to exercise and what to do with the shares afterward.

3. Restricted Stock Units

Restricted stock units (RSU) are different.  They are not a stock option so much as they are an award of stock.

Most stock options need a decision on your part.  You exercise the option.  You get the shares.

Restricted stock units have a vesting schedule, but you make no decision.  You receive shares as the RSU vest.  You do not have to exercise.

You pay tax on the full fair market value of the shares when they vest.

The only decision required with RSU shares is what to do with them after they vest.

Restricted stock units are sometimes referred to as restricted stock awards (RSA).

4. Stock Appreciation Rights

Stock appreciation rights (SAR or SSAR) have a vesting schedule.  You decide when to exercise but pay no exercise price.  You receive the difference in the stock price between the grant date and exercise.

For example, you receive stock appreciation rights at a price of $10 per share.  One year later 25% of the SARs vest and the stock is $15 per share.  You decide to exercise.

The exercise costs you $0.  You receive $5 for every SAR you exercise.  The $5 is taxable to you as ordinary income.

5. Incentive Stock Units

Incentive stock units give employees an interest in the future profits of the company.  Start ups structured as a limited liability company (LLC) may use incentive stock units.

Incentive stock units carry two unique provisions.  First, the incentive stock units are worthless if the company dissolves.

Second, the agreement will allow for filing of an 83(b) stating that when granted the units are worth $0.

Incentive stock units have a vesting schedule.  You do not exercise incentive stock units, and you receive no shares upon vesting.

Provided you file an 83(b), you are not taxed as the units vest.

37 Terms You Must Know to Make the Most Out of Your Employee Stock Options Now

Understanding your stock options starts by knowing the terms used to describe them.

Grant – Grant is the group of options given to you.  You receive a grant of stock options when you sign your stock option agreement.

Grant Date – The date upon which you receive stock options and vesting begins is your grant date.

Initial Grant – Your first grant of stock options is your initial grant.  Renewal grants are extra grants of stock options given to you in future years.  Your initial grant of stock options is usually the largest number of shares.

Vesting – Vesting is the time over which you take possession of your stock options.  The grant is the promise of stock options; vesting is the receipt of those options.

A period of time and frequency define vesting.  For example: 10,000 shares vesting over four years.  Twenty five percent of the shares vest after one year.  The remaining shares vest quarterly over the following twelve quarters.

An initial public offering (IPO) or acquisition may trigger vesting.  This is most common with grants of RSU by privately held companies.  Dual vesting RSU vest when the time and triggering event both pass.

Privately Held – Tech companies that have not gone through an initial public offering are privately held.  The founders, venture capital investors, and employees with stock options own the company.  A 409(a) valuation determines the fair market value of the company’s stock.

Publicly Traded – Publicly traded tech companies have gone through an initial public offering.  Shares of the company’s stock  trade on a stock exchange such as the Nasdaq.  The shareholders own the company.  Anyone with access to a brokerage account can buy shares.  The shares are easy to value; you can see the current FMV on any day that the stock exchange is open.

Initial Public Offering – The process of a tech company going from privately held to publicly traded.  Through an IPO shares of the company list on a stock exchange sell to the public.

Lock Up – A restricted period after the IPO when employees cannot sell shares.  The lock up usually lasts six months.

Black Out – Periods of time after IPO and lock up when employees cannot sell their shares.  Employees treated as insiders are restricted from trading during black out periods.

Open Trading Window – The opposite of a black out period.  A time when employees are free to sell shares of the company stock.  Open trading windows usually occur after the company reports quarterly earnings.

Liquid, Marketable – Shares that you can sell are liquid or marketable.  Stock in a publicly traded company is marketable.  You can sell shares during open trading windows on a stock exchange.  Stock in a privately held company may become marketable through an acquisition.

Acquisition – Another way that privately held shares can become liquid.  Acquisition is when the tech company you work for sells to another tech company.  The shares you exercised or vested RSU pay out as cash.

Vested – Vested stock options (ISO and NQ) are stock options you can exercise.  When you receive shares of stock from your restricted stock units (RSU), the RSU have vested.

Unvested – Unvested stock options (ISO and NQ) are not eligible for exercise.  Restricted stock units (RSU) from which you have yet to receive shares are unvested.

Cliff – Cliff is a point in your vesting schedule when a large number of shares vest at one time.  The most common example of a cliff would be:

10,000 shares vesting over four years in equal monthly installments with 25% vested after one year.

The “25% vested after one year” is the cliff.  You do not receive any of your stock options until the one-year anniversary of your grant.  After a year, you receive 2,500 shares.  The remaining 7,500 shares vest in monthly amounts of 208 shares per month.

Share – A share refers to a unit of ownership.  Owning shares of a company means that a percentage of the company belongs to you.  Many use the terms stock options and shares to refer to the same thing.  For example someone says, “My company granted me 10,000 shares of ISO.”  It is the same as, “My company granted me 10,000 stock options in the form of incentive stock options.”

You exercise your stock options to buy shares from the company.  This exchange of stock option for shares also occurs when restricted stock units (RSU) vest.

Expiration – Your stock options represent the option to buy shares of stock.  That option is not permanent.  Expiration is the date on which your stock options end.  Your ability to buy shares ends according to the terms of your stock option agreement.  The most common expiration date is ten years from the grant date.

Exercise – Exercise is the act of purchasing shares with your stock options.  You exercise by paying the exercise price, and you receive the shares.  Incentive stock options (ISO) and nonqualified stock options (NQ) both need an exercise to buy shares.  Restricted stock units (RSU) need no exercise; you receive shares as the RSU vest.

Exercise Price – The exercise price is the price you pay when you buy shares.  The exercise price is also referred to as the strike price.  Incentive stock options (ISO) and nonqualified stock options (NQ) both have an exercise price.  Restricted stock units (RSU) do not have an exercise price.

Bargain Element – The difference between your exercise price and the fair market value (FMV) of the company’s stock on the day you exercise.  If your exercise price is $1 and the FMV of one share of the company stock is $10, your bargain element is $9.  The bargain element determines what taxes you owe by exercising your shares.

409(a) Valuation – 409(a) refers to internal revenue code (IRC) section 409(a).  It is the part of the tax code that governs deferred compensation plans.  Stock options are a form of deferred compensation.

The IRS requires tech companies to issue stock options at the money.  409(a) valuations determine the fair market value of a privately held tech company.  Section 409(a) mandates the use of a, “reasonable application of a reasonable valuation method.”

The 409(a) valuation is updated every six months or any time the company raises a new round of funding.

Termination – Part of your stock option agreement.  Specifies what happens to your stock options if your employment ends.  Organized based on condition of the options (vested, unvested) and reason for termination (fired, quit, disability, death).  Read the provisions; know what choices you have in case your employment ends.

90 Days – You will have ninety days to exercise your vested options if you leave your job.  This is true for most tech companies; there are exceptions.  The 90 day provision applies to incentive stock options (ISO) and nonqualified stock options (NQ).  You lose unvested restricted stock units if your employment ends.

Ordinary Income Tax – Most income is taxed at ordinary income tax rates, which can be as high as 39.6%.  Ordinary income tax is one of three taxes you may pay on your stock options.  The alternative minimum tax and capital gains are the other.  You pay ordinary income tax on your bargain element when you exercise nonqualified stock options (NQ).  You also pay ordinary income tax when your restricted stock units (RSU) vest.  Ordinary income tax rates go up to 39.6%.

Alternative Minimum Tax – The alternative minimum tax (AMT) works with the ordinary income tax.  Different rules apply to the AMT.  You pay the tax that produces the highest tax bill (ordinary income tax vs AMT).  The AMT rates are as high as 28%.

Under the AMT, your bargain element is taxable on the exercise of incentive stock options.  You pay no tax when you exercise ISO under the ordinary income tax.

Alternative Minimum Tax Credit – You generate an alternative minimum tax credit when you pay AMT related to the exercise of incentive stock options.  The AMT tax credit creates a carry forward that is used in future years to reduce your tax liability.  The carry forward never expires.  You will need to file Form 8801 every year until you have no remaining AMT tax credit.

Capital Gains – Long term capital gains are lower than ordinary income tax rates.

You pay ordinary income tax rates on shares sold less than one year after exercise or vest.  Long-term capital gains rates apply to shares held longer than one year.  Long-term capital gains rates go up to 23.8%

Exercise and Hold – A strategy for handling incentive or nonqualified stock options.  You exercise and then hold the shares.

Exercise and Sell – A strategy where you exercise the stock options and sell the shares at the same time.  Also referred to as a same day sale.

Early Exercise – Early exercise is a feature offered by some tech companies.  Allows you to exercise your unvested stock options now without waiting on them to vest.  Not all tech companies allow for early exercise.

Cashless Exercise – Allows you to exercise without paying cash.  This applies to incentive stock options (ISO) and nonqualified stock options (NQ).

The company sells shares to cover the cost of exercising.  You receive the remaining shares.

Let’s say you have 100 incentive stock options with an exercise price of $1.  The shares have a fair market value of $10.  You exercise all 100 ISO with a cashless exercise.  The cost to exercise is $100 (100 ISO x $1 exercise price).  Ten shares sell to cover the exercise cost (10 shares x $10).  You receive 90 shares.

Cashless exercise is only available with publicly traded tech companies.

83(b) Election – A tax election made in coordination with the early exercise of stock options.  You must make the 83(b) election within 30 days of exercise.  Your company may provide you with a standard form to use for electing the 83(b).

Without the 83(b) election, you early exercise but pay taxes as your options vest.  The fair market value of the company goes up as your shares vest.  Your bargain element goes up too.  You pay more in taxes.

Filing an 83(b) avoids this.  The 83(b) tells the IRS to treat your stock options as if they vest now.  You pay tax on your bargain element today instead of as the shares vest.

Filing an 83(b) when the exercise price and fair market value equal can result in big tax savings.

Underwater – When the fair market is less than the strike price of the option.  Also called “out of the money.”  For example, you received 1,000 incentive stock options (ISO).  The strike price on your options is $5.  The stock’s fair market value is $4 per share.  Your incentive stock options are underwater.

At the Money – When the fair market value and strike price are equal.  Your strike price is $5.  The fairmarket value is $5.  Your stock options are at the money.

In the Money – The opposite of underwater.  The fair market value is greater than the strike price.  Your bargain element is positive.

What Reviewing 100s of Employee Stock Option Agreements for Dozens of Tech Companies Taught Us About How to Read Your Stock Option Agreement

Your stock option agreement is a legal document.  It’s not easy to read.

We see some common features that will help you read your stock option agreement.

  • Opening Paragraph – Your stock option agreement usually opens with an introductory paragraph.  It will read something like, “San Francisco Tech Company XYZ (the company) has granted to you (the participant)…”  The opening paragraph will contain a couple of important pieces of info.  First, it will tell you the type of option.  It will say, “a grant of Restricted Stock Units.”  Second, it will tell you the option agreement that governs your grant.  You will read, “pursuant to San Francisco Tech Companies YEAR Stock Option Agreement.
  • Grant Details – Usually presented as a bulleted list.  They are the quickest way to answer some basic questions.  What type of option?  When do they vest?  How many shares?  The grant details usually show up on the middle of the first page.  You should see:
    • Holder – you
    • Date of Grant – date you receive the options
    • Vesting Commencement Date – date the options start to vest
    • Number of Options – number of shares your options can buy
    • Exercise Price – the price you pay to buy shares (strike price)
    • Expiration Date – date the option to buy shares ends
    • Type of Option – incentive stock option (ISO), nonqualified stock options (NQ), restricted stock units (RSU)
    • Vesting Schedule – details how the options vest after the vesting commencement date
  • The Fine Print – Your stock option agreement will go into all the nitty-gritty after your grant details. You find some key pieces of info here.
    • Termination – Specifies what happens to your stock options if your employment ends.  Termination is usually broken into three causes.
      • Any Reason Except Death, Disability, or Cause – The most common reason is that you take another job.  This clause tells you how long you have to exercise your stock options.  Ninety days is most common.
      • Because of Death or Disability – Specifies what happens to your vested stock options if you die or become unable to work.  You (or your legal representative) may have a longer window to exercise.
      • For Cause – If you get fired for cause, this lets you know what happens to your stock options.
    • Early Exercise – Your stock option agreement should specify if early exercise is available to you.  Pay attention to how the early exercise and termination provisions coordinate.  What happens if you early exercise and leave the company with unvested stock options?
    • Repurchase – This may read as “Restrictions and Limitations on Transfer” or “Right of First Refusal.”  The company limits your ability to transfer shares before an initial public offering.  The restriction usually takes the form of a right of first refusal.  The company has the ability to buy shares back from you before you transfer the shares to someone else.

These are just a few of the important provisions found in your stock option agreement.  Review your stock option agreement to understand the options granted to you.

Nine Steps to Make Sense of Your Employee Stock Options

Take these steps to make full use of your stock options.

  1. Determine the Type of Options You Have – Make a list if you have to.  Look on your stock option agreement or grant sheet.  The type of option may be an acronym (RSU, ISO, NQ) or spelled out, “grant of 4,000 incentive stock options.”  You may be able to log-into your employee equity rewards account.  Common providers are Schwab, eTrade, Solium, UBS.  Your account summary screen should list your grants and the type of option with an acronym.
  2. Know Your Vesting Schedule – How does each grant vest?  Four-year quarterly vesting with a one-year cliff of 25%?  Your equity rewards account and stock option agreement should specify.  You may have more than one grant, each with different vesting schedules.
  3. Look Up Your Strike Price – This applies to incentive stock options and nonqualified stock options.  The strike price will be in your stock option agreement or equity awards account.
  4. See if You Can Early Exercise – Your stock option agreement will specify if early exercise is available to you.  Look for a clause in the legal terms of the document such as, “#. Early Exercise –“.
  5. Find the Most Recent 409(a) Valuation – This one can be tough.  You equity award center may show the 409(a).  It will not be on your stock option agreement.  Ask around: your boss, the person responsible for human resources, the chief financial officer.  Someone within the company should know.  Note – This is only for private companies.  Public companies trade on an exchange; their price is available every day the exchange is open.
  6. Review Your Last Tax Return – Your tax return is where we relate your stock options to the rest of your life.  Your tax return gives us a lot of clues about how much tax you may pay as you exercise or the options vest.  What was your taxable income last year?  Did you pay alternative minimum tax?  Did you pay the net investment income tax?  These are all questions that your tax return can answer.
  7. Project Your Income for This Year – Grab your most recent pay stub.  What date did your pay period end on?  If your pay period ended on the 15th or 31st, you have 24 pay periods per year.  This is the number of times you receive a pay check.  You have 26 pay periods if your pay period ends on an odd date like the 7th or 23rd.  Get out a calendar and count the number of pay periods that have past since January 1.  Subtract the number from 24 or 26 to determine the number of pay periods remaining till December 31.  Multiply the pay periods remaining times your gross income for this pay period.  This is your projected income for the rest of the year.  Now add this number to your year-to-date income from the pay stub.  This is your total projected income for the year.  How does this compare to last year?  More? Less?  The answers help us gauge the impact of exercising this year.
  8. Check Your Resources – Exercising incentive stock options and nonqualified stock options requires cash. How much cash do you have?  Can you take the risk of investing money in your company stock?  Is your debt under control?
  9. Decide What to Do – Handling stock options is a personal topic.  Your coworkers can tell you what they are doing but not what you should do.  Check your resources to determine if exercising is a good idea.  Look at your taxes to see if exercising NOW is a good idea.

Mo’ Stock Options, Mo’ Problems

Biggie knew what he was talking about.

Stock options are hard to understand.  They involve many decisions.  Each decision is an opportunity to experience a positive return or pay the cost of making a mistake.

Familiarize yourself with the common stock option terms.

Read and understand your stock option agreement.

Follow our nine steps to evelauate your options and your plan.

Ready to Save Time and Money?

Understanding your stock options take time.  Mistakes are costly.  Save time and money by scheduling a call with us today.

Since passing the Certified Financial Planner (CFP) exam in November 2009, Landon has dedicated himself to the needs of busy young professionals. Before joining KB Financial Advisors in 2012, Landon founded Cumberland Wealth Planners in 2010 to serve clients in Nashville, TN. Landon took over the On Your Way to Wealth program in 2014 to help KB Financial Advisors further expand their work with young tech professionals in San Francisco who have stock options.

When he’s not on a plane to San Francisco, Landon lives in Nashville, TN with his wife Melissa and their three children.


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