How Do Stock Options Really Work? Are They Worth It?

Giving stock options to employees is quickly becoming a regular practice among top companies to help attract talent and boost employee retention. Employee stock ownership also bolsters productivity by giving employees a stake in the company’s success.

Depending on the success of the company, these stock options may be worth a lot in the long run.

But what does it mean to have stock options? Are employees granted a profit just because they have them? And why are more and more companies including these in their compensation package?

The answers to these questions are important to give you a better understanding of what stock options are and if they’ll work for you.

In this guide, we’ll delve into what stock options are, how they work, and how they can work for you.

What Are Stock Options?

Stock options are an added compensation bonus that companies may grant to employees. These options are granted through a contract that allows employees to buy (or exercise) a set number of company stock shares at a set price (or grant price).

Employees have a set period of time to exercise their stock options before expiration. Expiration times differ per company. Usually, the expiration date is 10 years after the grant date.

The number of stock options a company will give also varies. This might depend on the seniority of the employee or the compensation package add-ons when enticing new talent.

Why Do Companies Offer Stock Options?

Over the past few years, companies have noticed that employee engagement and motivation is higher when employees have a stake in the company’s success. This is one of the reasons stock options have become such a popular practice.

Other reasons companies make stock options available include:

  1. They want to beef up their recruitment offers to attract talent.
  2. They want to give employees compensation that goes beyond just a salary. 
  3. For start-ups, they want to be partners with their employees in growing the business.

How Do Stock Options Work?

To learn how stock options work, let’s look at a simple example. Assume that you’ve just started a job and part of your compensation package is 10,000 stock options. The company will provide you a contract that explains the terms of these options.

Part of these terms is the vesting date or grant date. This means the day you can exercise or buy your stocks. You won’t be able to receive all of your options right away. Options vest gradually over a pre-determined vesting period.

The vesting period can be set up in one of two ways. Either options vest all at once (cliff vesting) or they vest in a series of parts over a specified amount of time (graded vesting).

Vesting periods are usually time/tenure-based, but in some cases, they can be based on goal achievement, corporate performance, or employee productivity.

For the sake of our example, assume your stocks have a five-year graded vesting period, with a six-month cliff. This means that it will take five years before you can exercise all 10,000 stock options.

But, because your options vest increasingly over time, you’ll have access to some even before the five-year mark.

Most likely, 20% of your options will vest each year. After one year of employment, you can exercise 2,000 options. This continues to increase per year until all 10,000 options can be exercised.

But don’t forget the six-month cliff as well. This is the designated waiting period before any of the options vest. You must stay with the company for a minimum of six months before you can receive any stock options. Should you leave before then, you forfeit them all.

How Do You Exercise Your Stock Options?

You can exercise your options once they vest. This means you may now actually buy the shares. Stock options don’t have any real value until they are exercised.

The price (known as the grant price) for stock options will be stipulated in the contract. This price won’t change over time no matter what happens to the company.

So going back to our example, after five years, you now have 10,000 stock options you can exercise at a grant price of $2. This means you must pay $20,000 to buy them all.

Once you exercise your stock options, you can hold them or sell them. This will depend on the market value of the stock.

Assuming the company does well, five years may have seen the stock price rise. If stock prices are at $6 on the market after you exercise them, this means you stand to earn $40,000 if you choose to sell (minus fees and taxes).

You may also hold the stocks and hope the price will continue to increase.

What if you don’t have the cash to exercise all your stock options? There are ways to exercise without putting up the money. These options include:

  1. Exercise-and-sell — This means purchasing your options and selling them outright. Instead of using your own money, the brokerage will front the payment using the money made in the sale to cover your costs and buy the shares.
  2. Exercise-and-sell-to-cover — This means selling just enough shares to cover the purchase cost and holding the rest. 

What Taxes Do I Have To Pay For Stock Options?

You’ll need to factor in taxes when exercising and selling stock options. The amount depends on the kind of options you have and the amount of time between exercising and selling.

There are two types of stock options:

  1. Non-qualified stock options (NQSOs) — These receive no special tax treatment.
  2. Incentive stock options (ISOs) – These receive special tax treatment.

NQSOs are taxed as regular income. The amount of income depends on the difference between stock market value and grant price. If you exercise your 10,000 options for $2, but they cost $6 on the market, the compensation element is $40,000. This goes on your W-2 as regular income.

When you sell your shares, you pay taxes based on how long you held them.

If you sell within one year of exercise date, you report it as short-term capital gains subject to regular federal income tax rates. If you sell after one year, you can report the sale as long-term capital gains, which are subject to lower tax rates.

For ISOs, you don’t pay taxes when you exercise; only upon selling. If you sell as soon as you exercise, the compensation element is treated as regular income. If you hold for one year and don’t sell until two years after the grant date, you pay long-term capital gains rates.

Are They Really Worth It?

Stock options are quickly becoming common practice for companies to incentivize employees and increase employee engagement and employee retention.

The answer to whether or not they are worth it depends on your long-term plans and your belief in your company’s future success.

If you’re committed to staying with a company for the long haul and confident that your company will continue to remain successful, then you stand to earn a big payoff from your stock options. Just be sure to carefully review the terms of your stock option contract.

Look out for the following details:

  1. The number of stock options you‘re entitled to receive
  2. Length of the vesting period
  3. Grant price for stock options

How and when you exercise your options will depend on these important factors and the stock’s market value. If you play your cards right, you can earn more than double your grant price by selling your stocks when the market price is high.