Stock options represent a contract that allows individuals to buy specific amounts of stock at a fixed price. Stock options are not actual equity or shares - just the potential (option) to buy them later. There are four critical points in time important to stock options:
In theory, stock options allow employees to own a piece of the company at a lower cost. This is advantageous to both the employee and the company: employees have the potential to make money on the shares they have while also having greater buy-in when it comes to the company’s success. The value of stock options thus relies on the assumption that a company will become more valuable over time.
Take the following example scenario: two companies grant the same stock option - 100 shares vesting over 4 years with a 1 year cliff date. This means that you get nothing for the first 12 months, at the 12th month 25%, and 1/48th every month thereafter (4 years x 12 months = 48 months. The exercise price per share given on the grant date is $1 per share. The value of exercised stock options at any given point (note that before year 1, when no shares have vested, there is no value) is the difference between the solid and dashed line. As the graphs demonstrate, this difference varies rapidly over time, directly tied to the value of the stock. This is an important characteristic of stock options to keep in mind - that their potential value to an employee is highly dependent on the company’s success.
Like many forms of equity compensation, stock options often follow a vesting schedule. Stock options can be exercised once they have vested (after the cliff date) during the exercise window. An individual can exercise stock options only for a specific amount of time before they expire.
Some companies offer early exercise, an employee-friendly policy that allows individuals to exercise before the options have vested. For example, if we go back to the scenario above (100 shares vesting over 4 years with a 1 year cliff date), an early exercisable stock option would allow the option holder to exercise all or a portion of the option immediately. Early exercise often requires approval from the board of directors and/or could be reflected in stock option paperwork.
Similarly, many companies offer opportunities for employees who have left their roles to continue to exercise their options. In the past, most companies opted for a 90 days after an employee was terminated (post-termination exercise period or PTE) for their window to remain open. This window was often considered too short.
In response, many companies have extended their exercise windows, for example:
Some external events that can trigger vesting are called accelerated vesting. A merger, acquisition, or any other change of control is an example of single trigger acceleration. Single trigger acceleration generally ceases some or all of the vesting restriction. Double trigger acceleration requires two events to trigger acceleration (i.e., a company is sold and everyone at the company is involuntary terminated).
Common Times to Exercise: Generally, the best times to exercise stock is when your shares are more likely to be liquid and/or have the highest market value
There are two types of employee stock options, Incentive Stock Options, and Non-Qualified Stock Options. The stock options differ most widely in who they can be awarded to and how they are taxed.
Incentive Stock Options are options that can only be granted to employees. They almost always expire 10 years after they are issued or 90 days after an employee is terminated - there are exceptions to this timeline that we’ll cover later. Incentive Stock Options get their name from their initial purpose - incentivizing employees to remain at the company and increase its value. ISOs are often seen as better to employees due to their favorable tax treatment.
Non-Qualified Stock Options can be granted more widely - to consultants, advisors, directors, or employees. Employers can claim a tax deduction for NQSOs.
There are three types of taxes most relevant to stock options:
At Exercise: No tax liabilities are owed for holders of ISOs at the time of exercise.
At Sale: AMT adjustment may be required depending on when purchase and sale is completed
Holders of ISOs should be aware of the 83(b) election, an IRS provision that allows those with stock options to pay taxes on the total fair market value when it is granted. For more on this, check out Complete’s article on taxation.
At Exercise: Taxed as regular income, not eligible for the 83(b) election. Taxes are based on the spread between the stock's Fair Market Value when it is purchased (market rate) and the exercise price (or strike price).
As we’ve discussed, private companies often have restrictions on selling stock. Liquidating shares in a private company can be a complicated process. There are however, some choices that employees can pursue when it comes to selling their exercised stock.
Bi-Lateral Secondary Transaction: A handful of companies (Forge, Equityzen) serve as online marketplaces for trading pre-IPO/private employee shares from private companies. These marketplaces help connect private stockholders with individuals seeking to purchase private stock.
Tender Offer (Buyback): A transaction where owners of the private stock sell it back to the company or outside investors. The seller (the employee with the original stock options) has the opportunity to earn money off their equity faster, rather than waiting for it to IPO. Buybacks usually occur between one (or a combination) of two buyers: the company the shares are in (a corporate repurchase) or a third-party (and investor or other company).
Both tender offers and bi-lateral secondary transactions must be approved by the company before they are finalized. Consult with your HR individual to see if this is an opportunity for you.
Together opportunities like these offer employees more autonomy in their equity-related financial decisions. Instead of being at the mercy of executive decisions (like acquisition, merges, and IPO), employees can have greater flexibility in their compensation.