Understanding Employee Stock Options

When asked about your compensation, you probably think about the amount you’re paid each month or year. However, other employee benefits like matching contributions to your 401(k), covering a portion of your health insurance, and granting stock options can be an overlooked part of your total compensation package. 

If your employer has offered you stock options but you’ve found yourself wondering what they are, how they work, and how to take advantage of them – you’ve come to the right place! 

What are Stock Options?

Stock options are contracts given to an employee which allows them to purchase (exercise) a certain number of company stock shares at a predetermined price (also known as the grant price, exercise price, or strike price). 

What most people may not realize is you don’t have to exercise the offered options, hence the name stock option. However, you do have a specific time frame to decide whether you wish to take advantage of the option before the opportunity expires. Typically, options expire ten years from the grant date. 

How Do Stock Options Work?

Before you get stock options, you will sign a contract with your company to outline the terms on which you receive the stock. For someone starting a job at a new company, your options contract may be included when you sign your employment agreement

This contract will outline a few important details, such as the grant date. The grant date is the day your options begin to vest. When your options vest, it means they are available for you to buy (exercise). Typically, vesting happens over a few years. 

Example:

You start at a new company and sign a contract that states you will receive 40,000 stock options. The contract states these options have a four-year vesting period, with a one-year cliff. A four-year vesting schedule means you don’t have to wait four years before you’re able to exercise your options. However, the one-year cliff means you do need to be with the company for one year before receiving any of your options. If you leave the company prior to the one-year mark, you forfeit your right to those options. 

How Does Exercising Stock Options Work? 

You can’t exercise your options until they vest. However, once they are vested you can buy shares of your company’s stock (i.e. exercising your options), at the predetermined price (grant price, exercise price, or strike price). Until you exercise, there is no real value to your employee stock options. 

Example: 

Your company granted you $40,000 stock options with a grant price of $1. Four years have passed and you decide to exercise all of your options. In order to exercise all of your vested options, you would need to pay $40,000 (40,000 shares x the grant price of $1). Once exercised, you own the actual stock shares and are free to either sell them for a profit (assuming the current stock value is higher than the grant price), or hold onto the shares in hopes the stock price will continue to rise. 

There are ways to exercise your options without paying to purchase the stock shares, also known as a cashless exercise. In this example, you would initiate a sell-to-cover transaction, which means after exercising your options you sell enough to cover the cost of purchasing the share and the possible cost of the income tax to be owed. 

Should You Exercise Your Stock Options?

Having stock options as a benefit can be exciting. Why? Because they provide an opportunity for wealth growth since the grant price remains unchanged – even if the fair market value of your company’s stock increases. Basically, if you’re able to purchase company stock at a lower price and sell it for a higher one, you can earn a significant amount of money on top of your annual salary. 

However, the potential for a big pay out also means you have a significant amount of risk. There’s no guarantee your company’s stock price will rise – in fact it could even drop. If you exercise your options and the current stock price drops, you could end up selling your shares for less than you originally paid. This is why it’s critical to have a financial plan and strategy in place when considering stock options.

Know What’s Right for You

Options are a common way for companies to attract and incentivize employees. While this compensation may not initially seem as impactful as a higher salary, the potential these options offer can be huge. If you have employee stock options through your employer, make sure you understand the underlying details of your contract. Reach out to an Abacus financial advisor today and let our expertise in handling this type of employee benefit be beneficial to you. 

To learn more about employee stock options and how to see if they’re right for you, check out this Work Your Wealth podcast episode featuring Laura Morganelli.

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