Owning a share of stock makes you an owner in that company. If you own a share of Apple stock, you are a part owner of Apple Inc and entitled to receive dividends the company pays, vote on matters that come before shareholders, etc.
Apple’s stock price (any public company’s) can be found at yahoo finance, on CNBC, in the Wall Street Journal, etc. Private companies hire an independent valuation firm each year to estimate their fair market value and share price.
An option is the right, but not the obligation, to buy a share of stock at a specified price (exercise price) for a specified period of time.
The exercise price is equal to the price of a share on the date you are granted options. You want the share price to increase over time so the difference between the share price and the exercise price (which doesn’t change), called the spread, grows very large.
There are two types of options, Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs or NSOs). They work the same way, but ISOs are potentially treated more favorably when it comes to taxes.
Grant date is when you receive your award of options and learn how many you get, the exercise price, the vesting schedule, and the expiration date.
Vesting usually happens over time and a typical vesting schedule is 4-year vesting with a one year cliff. This means that none of your options vest until you’ve been at the company for a year, ¼ of your options vest at that point, and the rest vest each month over the next three years.
Vesting date means you now own and can exercise your options (but you don’t have to).
Exercise date is when (if) you choose to use your options to buy shares of stock. You pay the exercise price per share, regardless of what the current share price is.
Sale of Stock date This is when you decide to sell shares. For employees of a private company, this is typically only after the company has had an IPO (or is sold).
Expiration date This is when your unexercised options are no longer valid, typically 10 years after grant date.
An IPO is an Initial Public Offering – the first time the company will sell shares (part of its ownership) to the public. The company hires an investment bank to underwrite the offering and they value the company, help sell shares to the public, and get shares trading in public stock markets.
Something else happens at an IPO – the lockup period starts. This is a period of time (often 180 days) during which investors, management, and employees are not allowed to sell shares.
BTW – you’ve probably been wondering how to estimate the value of YOUR options or shares. Here’s a simple approach – most companies’ shares are priced between $10 and $20 at IPO. So, multiplying the number of shares you have (or the number of options to buy shares) x $15 gives you a good approximation of the value you’ll have IF your company has a successful IPO.
The federal government has three ways to tax your income – as Ordinary Income, under the Alternative Minimum Tax (AMT), and as Capital Gains on the sale of an asset.
Ordinary Income (like your salary) is taxed at rates from 10% up to 39.6%. The AMT rate is 26% but applies to a larger amount of income as some tax deductions are added back and other items are added in. Short-term Capital Gains on assets sold one year or less after purchase are taxed as Ordinary Income. Long-term Capital Gains on assets sold longer than one year after purchase are taxed at 15%.
So generally speaking, Ordinary Income “is what it is”, AMT is “bad” and Long-term Capital Gains are “good”.
TAXES ON OPTIONS
There is no tax due at Grant or Vesting date.
At Exercise date, for NSOs, the spread is taxed as Ordinary Income while for ISOs the spread is included in your AMT calculation, and you may or may not owe AMT – this is the “potentially more favorable” tax treatment of ISOs.
At Sale of Stock date, there is tax due on the gain. Whether the sale date is less or more than one year from purchase (exercise) is the big determiner of whether you’ll pay Ordinary Income rates or lower Long-term Capital Gains rates.
BIG 3 CONSIDERATIONS
There are three things to keep in mind when thinking about what to do with your options:
1. Exercising your options means you are spending and risking your own money.
2. The likelihood of an IPO (or sale of the company) is lower earlier and higher later.
3. Taxes are lower earlier and higher later.
You now have a basic idea of the workings of employee stock options – feel good, stock options are a way for you to participate financially in the success of your employer! Download your Financial Check-up List now!