Finance

How Do Employee Stock Options Work? A Guide for the Rest of Us

Many companies allow their employees to own stock in the company. They do this to give employees an incentive to perform well and to offer a more attractive pay package without having to put up more cash. Stock options are one popular way for employers to offer stock to employees.

If your employer or a prospective employer is offering a stock option plan as part of your pay package, you will need to decide how valuable that plan could be to you.

Let’s take a closer look at stock options and how to assess their value.

What Are Stock Options?

Your company may give you the “option” to buy shares of their stock. For example, your company may allow you to buy 5,000 shares of stock at $10 per share.

Owning stock options is different than owning shares. Options provide you with the “option” to buy shares of a company at a fixed price. The options themselves have no cash value.

📘 An option = the right to buy shares at a set price.

📘 Strike price (grant or exercise price) = The fixed cost that you’ll pay per share in order to exercise your stock.

You will probably have to work for the company for at least a year before your options become available. At that time, it is “vested”. All that means is that you can use your options to buy stock. Until your options are vested, you just have to wait.

📘 Vesting = the conditions that need to be met for you to earn the right to buy stock.

The key point to remember about stock options is that they are not free. You will have to pay to exercise the option. You “exercise” your options when you purchase stock shares.

📘 Exercising stock options = to purchase shares of a company’s stock at a set price.

If you can’t afford to exercise the option or do not want to put up the cash, the option will eventually expire and you will no longer have the right to buy the shares at that price.

Life cycle of stock options

Stock Options vs. Restricted Stock Units (RSUs)

Companies may give you actual stock instead of an option to buy stock. These RSUs are basically a bonus paid with stocks instead of money.

You have to meet some requirements to get your RSUs. Requirements may be based on time with the company or the quality of your work.

✍️ Note: The “u” in “RSU” stands for “units.” Each unit represents a number of shares. You might find that in your company, for example, a unit contains 100 shares.

Restricted stock may be transferred to you according to a schedule. Much like stock options, you may receive RSUs in gradual increments as you stay with the company.

What is Vesting?

Most companies offer you a set number of options, let’s say 20,000, for example, and then those options become “vested” in successive years. So you could use 25% of your options one year, then 25% the next, and so on. The longer you remain at the company, the more options you get. However, this is not an endless amount. The company will limit you to a fixed total number of shares.

Your vested options have an expiration date, and if you let them expire, they are worthless. Options usually are good for ten years.

Stock Options in Public vs. Private Companies

If you’re considering accepting stock options as part of your compensation you have to know whether the company is public or private. This distinction is a key part of evaluating options.

The shares of a public company trade on a public exchange. You can check the value of the shares at any time. Once you own shares you can sell them at any time.

If you work for a privately owned company, it may be very difficult to assess the actual value of the shares you are offered. It will be hard to know whether the shares are worth more or less than the price you’re offered. It may also be difficult to find a buyer for your shares unless the company goes public.

📘 To go public = to become a company in which anyone can invest.

How Stock Options Benefit You

As an employee of a company, taking part in your company’s stock options allows you to own part of the company’s wealth. If the company grows, your stock also increases in value, and you will make a profit. Stock options motivate you to become more productive.

Risks of Using Stock Options

Employers like to call stock options a form of compensation. Using your options to buy stock does not guarantee that you’ll make money. You can also lose money. Of course, you also could make money. It all depends on whether the price of the stock rises or falls.

You will also have to put up cash and tie that cash up until you can liquidate your shares. If your employer is a privately held company there may be no market for your shares and you may wait for some time before you can sell them. That means you lose the benefit of other things you could have done with that money.

If you have the option to buy shares at $10, and the value of shares rises to $15, that is a good deal. You can purchase the shares at $10 each, and they are immediately worth $15 (if you decide to sell them).

On the other hand, if shares are only worth $8, there is no point in using your option to buy them because you will immediately lose money.

So you are taking a chance when you use your stock options. Despite what your company may say, you are not really getting extra compensation unless the shares go up in value.

How to Evaluate Stock Options in a Job Offer

Though employers may consider stock options as part of your pay, be wary of companies that want you to accept a lower salary because they are offering stock options.

Stock options and RSUs are not guaranteed income. They are speculative. You won’t be paying the rent or mortgage with them, and you can’t count on them to put food on the table. There is no guarantee that any stocks you buy will rise in value, including your employer’s stock.

Note that private company stock options can be tough to value. The worth of private company options depends on the value of the company. This requires comparing it to a similar private company. But of course, that value will change over time, so you are still left guessing. There is no solid reason to assign a value to them when negotiating your salary.

☝️ And don’t forget the tax costs.

You also should consider how long you intend to stay with the company. The vesting schedule may make it unlikely you will get your stock options before your leave the company.

Finally, you can be fired at will. There is no guarantee you will still be around when stock options become available.

So the way to evaluate stock options in a job offer is to view them as an extra. They are “nice to have,” but you need a guaranteed salary. Don’t mix up salary negotiations by thinking about stock options.


How to Buy Stocks Using Options

You will need a brokerage account. This is just a platform that gives you access to the stock exchanges. The broker executes your buy and sell orders. This method is for those who work for a public company – one that sells shares to the public.

☝️ Be aware that many online brokerages don’t charge you a fee for buying and selling stocks. Make sure you understand the terms and conditions.

If you work for a private company that does not sell shares to the public, you will have to buy directly from the company.

Ways to Pay for Shares

You are the one who pays for the shares. The company guarantees you a price, but you still have to use your own money to buy the shares.

If you want to exercise your options and you don’t have the cash, there are third-party companies that will provide you with money for the shares. The catch is that they will want a percentage of your profits. If you think you have a great opportunity, it might be worth giving up some gains. After all, if you let the opportunity go, you won’t make any money.

When to Exercise Stock Options

You have to wait until your options are vested. All that means is that you wait until the date you have permission to exercise them.

The other timing you should be aware of is related to the current market price. When you want to use options, check to make sure the stock price is higher than the price guaranteed by your options.

Wait until the market price goes above your option price. But you can’t wait forever. You must use your options before they expire because you can’t use them after that.

How to Sell Your Shares

Once you have purchased your shares, you may want to sell them. How you do that depends on whether you work for a private or public company.

Sell Public Company Shares

The shares of a public company trade on a public exchange. Anyone with a brokerage account can buy and sell them. If you already own publicly-traded company shares, you can simply sell them to a buyer on the stock exchange using your brokerage account.

💡 Tip: When you hear that a stock is “liquid,” that means it is easy to sell because there are a lot of potential buyers. In practice, it means that your stock is traded on stock exchanges. These exchanges have many buyers and it is rare for a stock to have no interested parties.

Sell Private Company Shares

So, how do stock options work in a private company?

A private company doesn’t sell to the public, but it may still have shares it sells to employees and company managers. Selling your private company shares can be done, but it is a bit trickier than selling public shares.

Here are the steps to take:

  1. Ask your company if you can sell your shares.
  2. Get the company’s valuation of your shares.
  3. Read and understand the agreement regarding selling the shares.

From time to time, your company may initiate a buyback program. This means it is willing to buy stock back from employees. Check to see if your company has such a program.

You can also sell your shares using a private equity brokerage. This has a cost, of course, but it is one way to get some value from your shares. You will need your company’s permission to do this.


What Happens to Your Stock Options if You Get Fired?

If you have unused stock options when you get fired, you can’t use them.

However, some companies may let you use your options to buy stock if you are temporarily laid off. This depends on company policy.

For example, during COVID, businesses had to cut back or even close down for a while. But they anticipated bringing all employees back eventually. In such a case, you might be able to buy stock in the company during the temporary layoff. If you see a short layoff coming, ask about company policy regarding stock options.

If you already used your options to buy shares, they belong to you even if you get fired. The company cannot take away your ownership of shares you already own.

What Happens to Your Stock Options if You Quit?

You lose all options you have not used once you leave the company. You don’t lose the shares you already bought, but you lose the unexercised options. 

Let’s say you have given two weeks’ notice to your employer. Since you are technically still an employee, the company may allow you to exercise your options to buy shares before the two weeks are up.

This is a good question to ask when you are first hired: What is the company policy on stock options when you leave voluntarily? This would only apply to options that are vested. Again “vested options” means the ones that are currently active based on how long you have been with the company.

What Happens to Stock Options in an IPO?

If you work for a private company, it may decide to become public. That means it will sell stock to the public on a stock exchange.

You have to wait until the IPO lockup period is over. Such a period can be 80 to 180 days, during which no one can buy or sell shares.

If you have vested options, you will have to wait to buy shares after the lockup period.

Your unvested options will become vested on the same schedule you already have. You will simply exercise these vested options after the IPO.

What Happens to Stock Options When a Company is Acquired

Let’s look at what happens to options when another company buys the one you work for.

Unvested Options

These may become worthless if the acquiring company won’t honor them. However, the company could pay you for your unvested options. If the acquiring company is generous, it may simply honor your vesting schedule and let you exercise options in the new company.

If it sounds like a gray area, it is. It all depends on the agreement between your current employer and the acquiring company.

Vested Options

The company that is buying the one you work for may pay you for vested options. Let’s be clear. We are talking about options that are currently available to you that you have not exercised. You can buy them, but you haven’t. You may be offered cash for such options.

The other possibility is that the acquiring company will let you use your options to buy its shares.


How are Stock Options Taxed

There are two kinds of stock options, plus RSUs. They are each taxed differently.

🌎 Note: The below tax information is based on U.S. tax law, and other countries may treat investment taxes differently. Check your local regulations.

ISO Taxes

You pay ISO taxes when you decide to sell your stock at a later date. You will pay tax on your profits and dividends. No immediate tax will be imposed when you take possession of the stock.

📘 Dividends = regular payouts some companies provide out of their profits.

Here is the tax breakdown for ISOs.

  • Profits on stocks you hold for at least one year before you sell qualify for capital gains tax. This is a lower rate than regular income tax. If you don’t sell the stock, you don’t owe anything.
  • Dividends and stocks you sell less than a year after you bought them are taxed at your regular income tax rate.

Taxes on Non-qualified Stock Options (NSOs)

You may be offered NSOs. They are called “non-qualified” because they don’t qualify for special tax treatment. Employers withhold tax on NSOs at the time they are given. Then you pay tax later on any gains you make from the stocks you buy.

RSU Taxes

Restricted stock is a bonus awarded as stock instead of cash, but it is taxed as if it were paid in cash. So you will pay regular income tax on RSUs.

How Do You Report the Exercise of Stock Options on a Tax Return?

You don’t have to report the fact that you used your stock options to buy shares. However, when you sell those shares, you list your profit or loss on Schedule D of form 1040.

For RSUs, you report your income as “other” in Box 14 of your W-2 form. You will pay tax on the value of the RSU.


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