How do employees exercise stock options

Understanding Employee Stock Options.

Does your new job offer stock options to you? For many it's a great incentive to join a new company. Google (GOOG) has to be the highest-profile example, with the legendary stories of thousands of original employees becoming multi-millionaires, including the in-house masseuse. Below is some information to help you understand stock options a little better if you’re confused about how they work.

Though employee stock options have lost a bit of their luster since the global financial meltdown -- being replaced more and more by restricted stock -- options still account for nearly one-third of the value of executive incentive packages, according to compensation consulting firm James F. Reda & Associates. Want stock options? You’re going to find them harder to find these days, mainly due to changes in the tax laws and recent blow-back from employees working for companies battered by the recession and tired of holding out-of-the-money, worthless options. In fact, employee stock options peaked in popularity back in 1999.

But if you score a gig with options, here’s how it will work.

Being granted stock options gives you the right to buy your company’s stock for a set price at a future date and for a specified time. We’ll use GOOG as an example.

Let’s say you were among those lucky “Nooglers” hired back when GOOG was issuing stock options at $500. You get the right to buy 1000 shares at $500 (the grant price ) after two years (the vesting period) and you have ten years to exercise the options (buy the shares).

If Google’s stock price is under $500 when your shares are vested they are out of the money and you’re out of luck. You don’t have to buy the shares at a loss, they just expire worthless, unless the stock rebounds and gets above its strike price -- or if the company generously decides to revalue the original exercise price.

But if GOOG is over $1000, as it is now, crack open the champagne – you’re in the money! You can buy 1000 shares at $500, then sell them and pocket a half million dollar profit. Just watch out for the ensuing tax bill.

In some cases, you can exercise your options and then hold on to the stock for at least a year before selling them and pay a lower tax rate. Options have a bunch of tax consequences to consider. If you have questions about your stock options, ask an advisor.

The downside of employee stock options.

In spite of that fact that options can make millionaires out of masseuses, there are some downsides:

Stock options can be a bit complicated. For example, different kinds of stock options have different tax consequences. There are non-qualified options and incentive stock options (ISOs), both having specific tax triggers. Options can expire worthless. Imagine the thrill of a grant followed by the agony of a stock flop. Rather than acting as an employee incentive, options issued for a stumbling stock can muck-up morale. Knowing when and how to exercise stock options can be nerve wracking. Has the stock reached its peak? Will it ever rebound from historic lows? Exercise and hold – or exercise and sell? And you can get way too invested in company stock. Holding a heap of options can lead to a windfall or a downfall. You just can’t bank on them until they’re in the money and in your pocket.

Employee stock options can be an extraordinary wealth-builder. With a rising company stock price and a vesting ladder, it’s almost like a forced savings account. And that can be an option worth taking.

Neda Jafarzadeh is a financial analyst for NerdWallet, a site dedicated to helping investors make better financial decisions with their money.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.

Get The Most Out Of Employee Stock Options.

An employee stock option plan can be a lucrative investment instrument if properly managed. For this reason, these plans have long served as a successful tool to attract top executives. In recent years, they've become a popular means to lure non-executive employees.

Unfortunately, some still fail to take full advantage of the money generated by their employee stock. Understanding the nature of stock options, taxation and the impact on personal income is key to maximizing such a potentially lucrative perk.

What's an Employee Stock Option?

An employee stock option is a contract issued by an employer to an employee to buy a set amount of shares of company stock at a fixed price for a limited period of time. There are two broad classifications of stock options issued: non-qualified stock options (NSO) and incentive stock options (ISO).

Non-qualified stock options differ from incentive stock options in two ways . First, NSOs are offered to non-executive employees and outside directors or consultants. By contrast, ISOs are strictly reserved for employees (more specifically, executives) of the company. Secondly, nonqualified options do not receive special federal tax treatment, while incentive stock options are given favorable tax treatment because they meet specific statutory rules described by the Internal Revenue Code (more on this favorable tax treatment is provided below).

NSO and ISO plans share a common trait: they can feel complex. Transactions within these plans must follow specific terms set forth by the employer agreement and the Internal Revenue Code.

Grant Date, Expiration, Vesting and Exercise.

To begin, employees are typically not granted full ownership of the options on the initiation date of the contract, also know as the grant date. They must comply with a specific schedule known as the vesting schedule when exercising their options. The vesting schedule begins on the day the options are granted and lists the dates that an employee is able to exercise a specific number of shares.

For example, an employer may grant 1,000 shares on the grant date, but a year from that date, 200 shares will vest, which means the employee is given the right to exercise 200 of the 1,000 shares initially granted. The year after, another 200 shares are vested, and so on. The vesting schedule is followed by an expiration date. On this date, the employer no longer reserves the right for its employee to purchase company stock under the terms of the agreement.

An employee stock option is granted at a specific price, known as the exercise price. It is the price per share that an employee must pay to exercise his or her options. The exercise price is important because it is used to determine the gain, also called the bargain element, and the tax payable on the contract. The bargain element is calculated by subtracting the exercise price from the market price of the company stock on the date the option is exercised.

Taxing Employee Stock Options.

The Internal Revenue Code also has a set of rules that an owner must obey to avoid paying hefty taxes on his or her contracts. The taxation of stock option contracts depends on the type of option owned.

For non-qualified stock options (NSO):

The grant is not a taxable event. Taxation begins at the time of exercise. The bargain element of a non-qualified stock option is considered "compensation" and is taxed at ordinary income tax rates. For example, if an employee is granted 100 shares of Stock A at an exercise price of $25, the market value of the stock at the time of exercise is $50. The bargain element on the contract is ($50 to $25) x 100 = $2,500. Note that we are assuming that these shares are 100 percent vested. The sale of the security triggers another taxable event. If the employee decides to sell the shares immediately (or less than a year from exercise), the transaction will be reported as a short-term capital gain (or loss) and will be subject to tax at ordinary income tax rates. If the employee decides to sell the shares a year after the exercise, the sale will be reported as a long-term capital gain (or loss) and the tax will be reduced.

Incentive stock options (ISO) receive special tax treatment:

The grant is not a taxable transaction. No taxable events are reported at exercise. However, the bargain element of an incentive stock option may trigger alternative minimum tax (AMT). The first taxable event occurs at the sale. If the shares are sold immediately after they are exercised, the bargain element is treated as ordinary income. The gain on the contract will be treated as a long-term capital gain if the following rule is honored: the stocks have to be held for 12 months after exercise and should not be sold until two years after the grant date. For example, suppose that Stock A is granted on January 1, 2007 (100% vested). The executive exercises the options on June 1, 2008. Should he or she wish to report the gain on the contract as a long-term capital gain, the stock cannot be sold before June 1, 2009.

Other Considerations.

Although the timing of a stock option strategy is important, there are other considerations to be made. Another key aspect of stock option planning is the effect that these instruments will have on overall asset allocation. For any investment plan to be successful, the assets have to be properly diversified.

An employee should be wary of concentrated positions on any company's stock. Most financial advisors suggest that company stock should represent 20 percent (at most) of the overall investment plan. While you may feel comfortable investing a larger percentage of your portfolio in your own company, it's simply safer to diversify. Consult a financial and/or tax specialist to determine the best execution plan for your portfolio.

Bottom Line.

Conceptually, options are an attractive payment method. What better way to encourage employees to participate in the growth of a company than by offering them to share in the profits? In practice, however, redemption and taxation of these instruments can be quite complicated. Most employees do not understand the tax effects of owning and exercising their options.

As a result, they can be heavily penalized by Uncle Sam and often miss out on some of the money generated by these contracts. Remember that selling your employee stock immediately after exercise will induce the higher short-term capital gains tax. Waiting until the sale qualifies for the lesser long-term capital gains tax can save you hundreds, or even thousands.

When Should You Exercise Your Stock Options?

S tock options have value precisely because they are an option . The fact that you have an extended amount of time to decide whether and when to buy your employer’s stock at a fixed price should have tremendous value. That’s why publicly-traded stock options are valued higher than the amount by which the price of the underlying stock exceeds the exercise price (please see Why Employee Stock Options are More Valuable than Exchange-Traded Stock Options for a more detailed explanation). Your stock option loses its option value the moment you exercise because you no longer have flexibility around when and if you should exercise. As a result many people wonder when does it make sense to exercise an option.

Tax Rates Drive the Decision to Exercise.

The most important variables to consider when deciding when to exercise your stock option are taxes and the amount of money you are willing to put at risk. There are three kinds of taxes you should consider when you exercise your Incentive Stock Options (the most common form of employee options): alternative minimum tax (AMT), ordinary income tax and the much lower long-term capital gains tax.

You are likely to incur an AMT if you exercise your options after their fair market value has risen above your exercise price, but you do not sell them. The AMT you are likely to incur will be the federal AMT tax rate of 28% times the amount by which your options have appreciated based on their current market price (you only pay state AMT at an income level few people will access). The current market price of your options is determined by the most recent 409A appraisal requested by your company’s board of directors if your employer is private (see The Reason Offer Letters Don’t Include a Strike Price for an explanation of how 409A appraisals work) and the public market price post IPO.

Your stock option loses its option value the moment you exercise because you no longer have flexibility around when and if you should exercise.

For example, if you own 20,000 options to purchase your employer’s common stock at $2 per share, the most recent 409A appraisal values your common stock at $6 per share and you exercise 10,000 shares then you will owe an AMT of $11,200 (10,000 x 28% x ($6 – $2)). If you then hold your exercised options for at least one year before you sell them (and two years after they were granted) then you will pay a combined federal-plus-state-marginal-long-term-capital-gains-tax-rate of only 24.7% on the amount they appreciate over $2 per share (assuming you earn $255,000 as a couple and live in California, as is the most common case for Wealthfront clients). The AMT you paid will be credited against the taxes you owe when you sell your exercised stock. If we assume you ultimately sell your 10,000 shares for $10 per share then your combined long-term capital gains tax will be $19,760 (10,000 shares x 24.7% x ($10 – $2)) minus the $11,200 previously paid AMT, or a net $8,560. For a detailed explanation of how the alternative minimum tax works, please see Improving Tax Results for Your Stock Option or Restricted Stock Grant, Part 1.

If you don’t exercise any of your options until your company gets acquired or goes public and you sell right away then you will pay ordinary income tax rates on the amount of the gain. If you’re a married California couple who jointly earn $255,000 (again, Wealthfront’s average client), your 2014 combined marginal state and federal ordinary income tax rate will be 42.7%. If we assume the same outcome as in the example above, but you wait to exercise until the day you sell (i. e. a same day exercise ) then you would owe ordinary income taxes of $68,320 (20,000 x 42.7% x ($10 – $2)). That’s a lot more than in the previous long-term capital gains case.

83(b) Elections Can Have Enormous Value.

You will owe no taxes at the time of exercise if you exercise your stock options when their fair market value is equal to their exercise price and you file a form 83(b) election on time. Any future appreciation will be taxed at long-term capital gains rates if you hold your stock for more than one year post exercise and two years post date-of-grant before selling. If you sell in less than one year then you will be taxed at ordinary income rates.

The most important variables to consider in deciding when to exercise your stock option are taxes and the amount of money you are willing to put at risk.

Most companies offer you the opportunity to exercise your stock options early (i. e. before they are fully vested). If you decide to leave your company prior to being fully vested and you early-exercised all your options then your employer will buy back your unvested stock at your exercise price. The benefit to exercising your options early is that you start the clock on qualifying for long-term capital gains treatment earlier. The risk is that your company doesn’t succeed and you are never able to sell your stock despite having invested the money to exercise your options (and perhaps having paid AMT).

The Scenarios Where It Makes Sense to Exercise Early.

There are probably two scenarios where early exercise makes sense:

Early in your tenure if you are a very early employee or Once you have a very high degree of confidence your company is going to be a big success and you have some savings you are willing to risk.

Early Employee Scenario.

Very early employees are typically issued stock options with an exercise price of pennies per share. If you’re fortunate enough to be in this situation then your total cost to exercise all your options might be only $2,000 to $4,000 even if you have been issued 200,000 shares. It could make a ton of sense to exercise all your shares before your employer does its first 409A appraisal if you can truly afford to lose this much money. I always encourage early employees who exercise their stock immediately to plan on losing all the money they invested. BUT if your company succeeds then the amount of taxes you save will be ENORMOUS.

High Likelihood of Success.

Say you’re employee number 80 to 100, you’ve been issued something on the order of 20,000 options with an exercise price of $2 per share, you exercise all your shares and your employer fails. It will be awfully hard to recover from that $40,000 loss (and the AMT you likely paid) both financially and psychologically. For this reason I suggest only exercising options with an exercise price above $0.10 per share if you are absolutely certain your employer is going to succeed. In many cases that might not be until you really believe your company is ready to go public.

The Optimal Time to Exercise is When Your Company Files For an IPO.

Earlier in this post I explained that exercised shares qualify for the much lower long-term capital gains tax rate if they have been held for more than a year post-exercise and your options were granted more than two years prior to sale . In the high likelihood of success scenario it doesn’t make sense to exercise more than a year in advance of when you can actually sell. To find the ideal time to exercise we need to work backwards from when your shares are likely to be liquid and valued at what you will find to be a fair price.

Employee shares are typically restricted from being sold for the first six months after a company has gone public. As we explained in The One Day To Avoid Selling Your Company Stock, a company’s shares typically trade down for a period of two weeks to two months after the aforementioned six-month underwriting lockup is released. There is usually a period of three to four months from the time a company files its initial registration statement to go public with the SEC until its stock trades publicly. That means you are unlikely to sell for at least a year post the date your company files a registration statement with the SEC to go public (four months waiting to go public + six month lockup + two months waiting for your stock to recover). Therefore you will take the minimum liquidity risk (i. e. have your money tied up the least amount of time without being able to sell) if you don’t exercise until your company tells you it has filed for an IPO.

I always encourage early employees who exercise their stock immediately to plan on losing all the money they invested. BUT if your company succeeds then the amount of taxes you save will be ENORMOUS.

In our post, Winning VC Strategies To Help You Sell Tech IPO Stock, we presented proprietary research that found for the most part only companies that exhibited three notable characteristics traded above their IPO price post-lockup-release (which should be greater than your options’ current market value prior to the IPO). These characteristics included meeting their pre-IPO earnings guidance on their first two earnings calls, consistent revenue growth and expanding margins. Based on these findings, you should only exercise early if you are highly confident your employer can meet all three requirements .

The higher your liquid net worth, the greater the timing risk you can take on when to exercise. I don’t think you can afford to take the risk to exercise your stock options before your company files to go public if you’re only worth $20,000. My advice changes if you’re worth $500,000. In that case you can better afford to lose some money, so exercising a little earlier once you are convinced your company is going to be highly successful (without the benefit of an IPO registration) may make sense. Exercising earlier likely means a lower AMT because the current market value of your stock will be lower. Generally I advise people not to risk more than 10% of their net worth if they want to exercise much earlier than the IPO registration date .

The difference between the AMT and long-term capital gains rates is not nearly as great as the difference between the long-term capital gains rate and the ordinary income tax rate. The federal AMT rate is 28%, which is approximately the same as the combined marginal long-term capital gains tax rate of 28.1%. In contrast an average Wealthfront client typically pays a combined marginal state and federal ordinary income tax rate of 39.2% (please see Improving Tax Results for Your Stock Option or Restricted Stock Grant, Part 1 for a schedule of federal ordinary income tax rates). Therefore you’re not going to pay more than long-term capital gains rates if you exercise early (and it will get credited against the tax you pay when you ultimately sell your stock), but you still need to come up with the cash to pay it, which may not be worth the risk.

Seek The Help of a Professional.

There are some more sophisticated tax strategies you might consider before you exercise public company stock that we outlined in Improving Tax Results for Your Stock Option or Restricted Stock Grant, Part 3, but I would simplify my decision to the advice stated above if you’re only considering exercising private company stock. Boiled down to simplest terms: Only exercise early if you’re an early employee or your company is about to go public. In any case we strongly recommend you hire a great tax accountant who is experienced with stock option exercise strategies to help you think through your decision prior to an IPO. This is a decision you’re not going to make very often and it’s not worth getting wrong.

The information contained in the article is provided for general informational purposes, and should not be construed as investment advice. This article is not intended as tax advice, and Wealthfront does not represent in any manner that the outcomes described herein will result in any particular tax consequence. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. Wealthfront assumes no responsibility for the tax consequences to any investor of any transaction. Financial advisory services are only provided to investors who become Wealthfront clients. Past performance is no guarantee of future results.

About the author.

Andy Rachleff is Wealthfront’s co-founder, President and Chief Executive Officer. He serves as a member of the board of trustees and vice chairman of the endowment investment committee for University of Pennsylvania and as a member of the faculty at Stanford Graduate School of Business, where he teaches courses on technology entrepreneurship. Prior to Wealthfront, Andy co-founded and was general partner of Benchmark Capital, where he was responsible for investing in a number of successful companies including Equinix, Juniper Networks, and Opsware. He also spent ten years as a general partner with Merrill, Pickard, Anderson & Eyre (MPAE). Andy earned his BS from University of Pennsylvania and his MBA from Stanford Graduate School of Business.

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Do Stock Options Terminate With Employment?

ESOs can allow employees to buy company stock at below-market rates.

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Employers sometimes use employee stock options, or ESOs, as a financial incentive for employees. ESOs give employees the option to buy company stock at a future date at a price established when the option is granted. Employees do not pay for their stock until they exercise their options. ESOs do expire, and employees who leave the company typically have only a short time to exercise their stock options.

Statutory and Non-statutory Options.

The Internal Revenue Service classifies ESOs as either statutory or non-statutory. If the employee can immediately exercise an option in full or transfer the option, it is likely a non-statutory option. The IRS has no provisions requiring expiration dates for non-statutory options. The rules are different for statutory option plans. Depending on the plan, employees have up to 90 days after their employment ends to exercise the option unless they become disabled, in which case the IRS extends the deadline to one year. However, the company's plan can reduce the time to exercise options after termination.

Most statutory ESOs require employees to be vested before they can exercise the options. Vesting simply means that employees must work for the company for a certain period of time to earn the right to exercise their stock options. Most plans divide the total number of options over a period of several years and grant purchase rights on a percentage basis. For example, an employee receives the option to buy 1,000 shares of stock. Assuming the vesting rate is 25 percent per year, the employee can buy 250 shares after working for the company for one year. If he does not exercise his option, after two years, he can buy 500 shares, 750 shares after three years or 1,000 shares after four years. When an employee leaves the company, his exercise rights are typically limited to the amount he has vested.

Stock Option Plans and Options Agreements.

Companies must prepare two documents related to employee stock options. The first is the stock options plan, which is approved by the company's board of directors and provides information of the rights of the employees covered by the plan. The second is the options agreement, which is normally prepared on an individual basis. This document spells out the price per share the employee must pay, how many shares the company is granting and how the employee will become vested in the plan. Either of these documents should contain the details on exercising options if employment terminates. The plan can require terminated employees to exercise their stock options within 24 hours of termination, for example, or grant them 30 days. Plans and agreements can also contain provisions that do not allow certain employees to exercise their ESOs, such as employees leaving the company to go to work for a competitor. Employees dismissed for cause, such as embezzlement or excessive unauthorized absences, may also forfeit their options under a plan's provisions.

Blackout Dates.

The company's ESO agreement or plan may contain certain dates that employees cannot exercise options or sell stock purchased through options. For example, the plan may require employees to hold their shares for a fixed time before selling them or forbid sales during the final month of the company's fiscal year. Terminated employees should pay careful attention to any blackout dates listed in their company plans or agreements to avoid losing their options. For example, if an employee is terminated on November 20 and the plan provides 30 days to exercise options but forbids employees to exercise options during the month of December, the terminated employee actually has only 10 days to exercise his options.

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Jeffrey Joyner has had numerous articles published on the Internet covering a wide range of topics. He studied electrical engineering after a tour of duty in the military, then became a freelance computer programmer for several years before settling on a career as a writer.

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