Stock Options 101: The Beginner’s Guide to Company Equity

by | May 27, 2021 | Stock Options

employee stock options 101

Scenario: 

You just got offered an exciting job at a cool, new startup.

???? ???? Heck. Yes. 

It’s a dream job, and you’re stoked to have it.

You’ll be responsible for a lot of cool things you haven’t done before, you’ll get a TON of hands-on experience to grow your career, and you get some cool equity options, which 100% have the potential to make you a millionaire one day. ????

Pretty sweet, no? 

Of course. It’s. Awesome.

Until…. 

You start reading up on your equity offers and the stock options you’ll have and realize you have no idea what most of that vocabulary means. ????

Or how most of it works. ????

You realize you’re in desperate need of “Stock Options 101.”

But no worries: 

In this post, I’ll walk you through the basics of stock options, so you know what you’re working with, and how to start using your stock options to build wealth, even if your company is nowhere near an IPO yet. 

 

1. Stock Options 101: What are Stock Options?

If your company provides you stock options, they’re essentially providing you partial ownership (or the opportunity to purchase partial ownership) of the business. 

The benefits of this are three-fold: 

  • One, a startup may not be able to provide as high of a salary as a well-established company (or as much resume clout), so giving pre-IPO employees equity in the company gives them a sort of reward for taking that risk. 
  • Two, when everyone working for the company has some skin in the game, everyone is dedicated to making the company successful, which almost always ensures a better outcome for everyone. 
  • Three, when the IPO or an acquisition does happen, you can cash out and make bank. 

But, when you’re granted an options package, you’ll see you’ve more than one type of stock option to work with and plan for as you grow your career and grow your wealth. 

Stock options come in 3 main types: 

  • Incentive Stock Options (ISO)
    • ISOs give you the opportunity to purchase shares of your company at a fixed price… fixed meaning the strike price stays the same no matter how high the stock later gets.  Normally, the longer you work for a company, the more ISOs you have access to.
    • The price you’re able to purchase stock via your ISO with is called your strike price. 
    • ISOs do not count as ordinary income at exercise so it may be possible to avoid tax when you exercise. More on taxes later.
  • Restricted Stock Units (RSU)
    • Instead of getting the “option” to purchase company shares, RSUs are issued over time and directly give you shares in the company without you having to pay anything. 
    • RSUs “vest” over time, and usually require two triggers to vest: the first one is time spent working for the company, and the second one is an IPO or an acquisition. 
    • RSUs are taxed at the same rate as ordinary income when they vest & you become the owner of those shares at the current market rate. 
  • Nonqualified Stock Options (NSO)
    • NSOs are considered “non-qualified” because they don’t quite meet all the requirements needed to be ISOs… The main difference is that NSO do count as ordinary income when you exercise.
    • With NSOs (like ISOs), you have the opportunity to purchase company shares at a predetermined price. 
    • When you exercise these options, you’ll owe tax on the bargain element. 
      • Bargain element = Number of shares x (market price – strike price)

To learn more, read: 

2. How & When Can You Use Stock Options?

The next step in Stock Options 101 is knowing where & how you can actually use them. 

If you’re excited about the wealth-building opportunities of equity, you might be ready to start using your stock options right away.  

But just because you have options doesn’t mean you can (or should) exercise them willy-nilly. 

For one, there’s tax planning to do, but we’ll get to that in a minute. 

The real reason though, is most stock options inherently have some kind of time-based restriction built in. 

Vesting Schedule Restrictions

The first restriction is your vesting schedule. 

It’s highly unlikely that any company would dump ALL of a person’s stock options on them in their first month of employment. For one, vesting stock options work as an incentive to keep employees over the long-term: the longer you work, the more options you have. 

So in order to use or exercise any of your options, you’ll have to first wait until you actually vest some. 

NOTE – Just like any rule, there are exceptions. Your company may allow you to early exercise before your options vest. See this post… How to Save $420,000 in Taxes

After some ISO or NSO vest, you can use those options to purchase shares at your strike price, up to the amount of share options you’ve vested. If you exercise everything, you’ll have to wait until your next vesting date to exercise more. 

Your RSU may also be double-trigger RSU, meaning you don’t get those shares into your possession until after you pass certain vesting benchmarks and an event in the company happens, which is usually the IPO. 

IPO-Based Restrictions

Most of your wealth from stock options will come from being able to exercise your options for shares, and then turning around and selling those shares for a profit. 

Occasionally you’ll be able to sell some shares during a tender offer or during a company acquisition, but most of the time you’ll have to wait to actually cash in on your options until the IPO happens and you’re able to sell your shares to the open market.

Open Trading & Lockout Windows

Even when an IPO does happen, you probably won’t be able to sell your shares on day one. 

Most companies impose a six-month lockout period on their employees, so they don’t immediately flood the market with their shares and drive the price down. If your company has gone through an IPO and you know you’ll want to sell, make sure to mark the open trading windows & the lockout windows on your calendar so you can take advantage of selling when you’re allowed to. 

To learn more, read: 

3. Stock Options Timing: Differences Between Before & After an IPO

If you can’t sell your shares until an IPO happens… should you even bother exercising your stock options before then? 

It’s up to you. 

Some people like to do a same-day sale where they exercise their stock options to buy shares at one price, and then immediately turn around and sell them at the higher market rate for a profit. This kind of quick turn-around obviously can’t be done until after the IPO, so why would you bother losing money from exercising your stock options before an IPO? 

This comes down to your long-term investment and wealth-growing strategy. 

For one, if you buy shares and hold onto them for at least 12 months before you sell them, you qualify your earnings from those shares for long-term capital gains tax, which is lower than standard income tax. This means you get to keep more of your money on the trade, and if your trade is large enough, that could amount to tens of thousands of dollars. 

Two, if you believe in the long-term vision and success of your company, you can slowly buy up stock over time without causing a huge financial hit on your budget in one month. Then, when the IPO happens, you’ll have an accumulation of shares (many of which qualify for a lower tax rate due to long-term capital gains) that you can sell for a profit.

Finally, if you join a company early enough, your shares may even qualify as qualified small business stock (QSBS), and you may not have to pay any taxes on capital gains if you’ve held the shares for long enough. 

To learn more, read: 

4. Planning Taxes for Stock Option Exercise

I’ve mentioned it briefly above, but before you exercise (or sell) any of your stock options, you need to plan out your taxes so you’ll know what kind of bill you’ll be dealing with come April. And to make sure you can actually afford the bill you’ll have to pay. (After all, what kind of Stock Options 101 piece would this be without talking about taxes? ????)

With RSU: your taxes are pretty straightforward: as soon as they vest into your possession, their value is taxed at the same rate as ordinary income. 

But with other equity types, things can get a little more confusing. 

For example, when you exercise ISO, you can exercise as much as you want, but if you exercise past a certain threshold (which is unique to every person’s financial situation), you’ll have to pay the Alternative Minimum Tax on top of the regular tax you owe. 

This can be difficult to calculate, especially if you’re not familiar with this section of the tax law. (Most non-tax accountants aren’t.) 

This is why it’s so important to work with an experienced, certified financial planner and tax preparer.




To learn more, read:

 

5. Stock Options + Career Development

The great thing about working for a company with stock options is that they reward you for taking a chance on a new, up-and-coming company. 

The not-so-great thing about working for a company with stock options is that once you leave the company, most of your unused stock options (that you haven’t paid to turn into shares) will go to waste… especially if you want to  move on and the company hasn’t gone through an IPO yet. 

If most of your net worth is tied up in unexercised stock options at a still-private company, you’ll want to figure out a way to exercise as many as possible so you can turn them into shares before you leave and start your next position. 

You can work with a financial advisor to figure out how much it would cost you to exercise everything upfront… or what your affordability limit is. 

You could ask for a sign-on bonus from a new employer to help you cover the cost of exercising, get a line of credit to cover the exercise, or even do an ISO to NSO conversion with extended exercise window post-termination if your company is open to it. 

Things get a little complicated here, but the important thing to know is there are always choices to work with, and moving on in your career doesn’t necessarily have to mean giving up on the stock options you worked so long to accumulate. 

To learn more, read:

6. Advanced Strategies for Stock Options

Beyond knowing the limitations and tax rules around stock options, there are some really, really cool things you can do with them to advance your financial plan. 

You can use stock options to do things like buying a house, paying for college, or even “recycling options” to increase your payouts when you don’t have a lot of money to invest in exercising upfront. 

It’s always important to work with a financial advisor when you’re executing one of these strategies because the math can get complicated… but it’s really cool that having stock options gives you these financial opportunities you wouldn’t otherwise have. 

To learn more about these strategies, read: 

Understand Your Stock Options & Get a Solid Plan Together

The cool thing about stock options is that once you understand what’s available to you, you can work with a financial advisor to put together a strategic, easy-to-follow plan. These plans are based on your personal financial situation, your goals, and putting you in the best position possible to take advantage of an IPO, tender offer, or acquisition when they happen. 

Use our contact page to pick a time for a complimentary call with one of our advisors to see what we can do for you, and how we can work together to really change the trajectory of your financial future. We’ll go over “Stock Options 101” for your personal situation and work on finding a plan that works best for you.