This Is How Stock Options Work

Employee stock options can benefit a company and its employees.

Stock options offer employees a chance to participate in the growth of a company and its share price. Options are granted for many reasons, ranging from recognition of service time or performance to an effort to attract and retain high-quality employees. For many employees, however, the question remains: What are stock options?

Employee stock options, aka ESOs, are different than put-and-call options on the public exchanges because they’re only valuable if the company stock goes up, not down. Most employee stock options come with numerous restrictions as to when they can be used and include tax provisions, but because you’re given stock options, you don’t have to worry as much about the impact of loss.

Many Facebook and Google employees have become millionaires thanks to stock options. Although stock options don’t guarantee an overnight fortune, they could result in a big payoff with little risk if your company is successful.

Here’s a closer look at the life cycle of an ESO and how it works.

How Stock Options Work

The life of an option begins when it is granted to an employee. Options, which are typically nontransferable, are often granted as part of an employment contract or as a reward.

When you receive your option package, you’ll be given the exercise price — the price at which you can buy the underlying stock to which the option is attached. You’ll also receive the vesting schedule, which indicates when stock options become exercisable — meaning you have the right to buy the stock at the strike price.

Say you’ve already been at the company a number of years and are fully vested in your options, which were granted with a strike price of $40, and the stock is currently trading at $50 per share. Your option would be worth $10 per share if you were to exercise it. The difference between the current market value of a stock and an option’s strike price — in this case, $50 less $40 — is the actual value you’ll receive.

You can then either keep the stock if you think it will go higher, or sell it and take your profit; in some cases, you can even sell enough of the stock to pay off the cost of the option. But, even if the value of the stock never gets above the strike price, you haven’t lost any money because you never paid for the option that was granted to you.

Options are popular in startup companies because they offer the potential of a huge payoff if the company goes public or trades on a public stock exchange so anyone can buy its shares. An early stage company might have stock worth 25 cents, for example, but if it goes public, that stock could trade at $20 per share or much higher.

Taxes and Stock Options

ESOs come in two types, incentive stock options — aka ISOs — and non-qualified stock options — NSOs — and each is taxed differently. For both types of options, there’s no tax consequence to the employee at the time of the grant, and with an ISO, there’s no tax effect upon exercise.

But with an NSO, the difference between the exercise price and the current market price of the stock is taxable as ordinary income. For example, if you exercise the option at $40 and the stock trades at $50, you’re immediately liable for $10 per share of ordinary income. And if you continue to hold the stock, its eventual sale will be taxed as a capital gain.

Learn: 8 Things to Know About Capital Gains Tax

For ISOs, tax is only paid upon the sale of the acquired stock, and the gain on the sale of the stock is taxed at the capital gains rate if it has been held longer than one year after exercise and the grant date is at least two years prior. Unlike NSOs, a $10 per share gain would be taxed as a capital gain, rather than as ordinary income. As of 2018, capital gains on stock sales could be as low as zero but are typically no higher than 15 percent for the average taxpayer.

Benefits and Drawbacks of Stock Options

Stock options are generally nothing but favorable for employees, as an option grant is essentially a bonus payment from an employer. When dealing with your options, however, there are still some things to keep in mind:

Pros of Stock Options

Pros typically outweigh the cons of employee stock options. Here are some example benefits of stock options:

  • No cost to employee at grant
  • No tax to employee at exercise for ISOs
  • Ability to participate in the growth of a company and its share price

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Cons of Stock Options

Although stock options are meant as a reward, be aware of potential cons. Take a look at these examples of the disadvantages of stock options:

  • Ordinary income taxation at exercise for NSOs
  • Vesting schedule delays ownership
  • As valuation of company’s stock declines, so do values of options

You should view a stock option plan as a part of your overall compensation. Although it might not immediately put money in your pocket, it could pay off handsomely over time. When you participate in stock options trading on the public market, you put your capital at risk. An employer-sponsored option plan, on the other hand, gives you the chance to participate in future upside without any downside risk.

Up Next: 6 Small Investment Ideas When You Have Less Than $500

Cynthia Measom contributed to the reporting for this article.