There are two types of stock options available through certain employers: employee stock options and restricted stock options (RSUs). While stock option plans are riskier than restricted stock options—which as their name implies, have restrictions—their potential for profit is higher, and investors should take advantage of stock option plans when given the opportunity.
How Does an Employee Stock Option Work?
An employee stock option (ESO) is awarded in unvested shares with a staggered vesting schedule. When you are awarded an employee stock option, you are given the option to purchase your company’s stock in the future, before the option expires, at the price of the stock the day you received them. When you exercise the option, it is usually a cashless transaction. Unlike restricted stock units (RSU), there is no taxable event when they vest. However, when they vest, there is typically an expiration date for when you must exercise them or you lose the option.
For example, let’s assume your company awarded you 10,000 shares of stock worth $10 per share. When the shares vest, every dollar they increase over $10 is worth $10,000 to you before taxes. so if the stock is worth $25 per share on the day you exercise, you experience the $15 per share growth, or $150,000.
How Are Company Shares Taxed?
With stock options, you are taxed upon exercising the option. Since it’s an immediate purchase and sale, you are taxed based on ordinary income tax rates. Some companies will allow you to actually purchase the option. If you are able, you could possibly avoid paying taxes at ordinary income tax rates. If you own the option for more than a year before exercising it, you would instead pay taxes at a long-term capital gains rate.
To take advantage of this your company has to allow it, and you would need to be able to afford the purchase. In the example above, you would need $100,000 just to cover the 10,000 shares. (For related reading, see: Get the Most out of Employee Stock Options.)
Although stock options can be lucrative, they also run the risk of being worthless. the option is only worth money for every dollar it increases over the issue price. If you receive stocks at $10 per share and over the lifespan of your option it never goes above that $10 again, your option would expire in a state referred to as out of the money. It doesn't make sense to purchase a stock for $10 if the fair market value is $5.
Why Do Companies Give Stock Options?
Generally, stock options are awarded to executives in publicly traded companies. They are a great way to both compensate and incentivize these high-level employees. Stock options allow employees to partake in the profitability of the company, and it’s hard for someone to walk away from many years of stock options, especially if there is substantial unvested value.
How do companies determine the value of the stock option?
When a company gives an employee a stock option, it has no value on day one. The option price to exercise is the same as the stock price. So, how do they assign a value to these options? Most companies use the Black-Scholes model to determine a fair price based on the expected price, growth and time horizon of the option. Although it is far from an exact science, it offers a good way to assign value to an otherwise seemingly worthless option.
Use Employee Stock Options to You Advantage.
Despite being riskier than their restricted stock unit counterparts, employee stock options can have a greater positive long-term effect on your financial success.
(For more from this author, see: Market Corrections: Preparing for the Inevitable.)