January 12, 2022
Maybe your new job offer comes with stock options, or maybe a friend’s been bragging about an equity stake in their company. The buzzwords sound very promising, but what do they actually mean for you financially? What are stock options for employees, and how do stock options work in general?
If you’re unclear what this all means, this guide is for you. Let’s start with the basics.
A stock option is a financial instrument known as a derivative.
Stock options give investors the right to buy a stock at a specified price, before or on a specified date.
How do stock options work, exactly? Let’s look at an example.
For example, you could own a stock option on company “XYZ” with a $10 strike price and an expiration date of January 1st, 2024.
In this example, the option would give you the right (but not the obligation) to buy 100 shares of XYZ at $10 per share (the “strike price”), at any time between now and January 1st, 2024.
One stock option is good for 100 shares of the stock. In this case, if you had one XYZ stock option contract, you could purchase 100 shares of XYZ for $1,000 at any time between now and the expiration date.
You don’t have to buy the stock, though—as the name suggests, stock options give you the option to buy the stock if you want to, but you are not obligated to do so.
If stock options merely give you the option to purchase the stock, are stock options worth it? What’s the point?
Returning to the example above, let’s say that it’s October 2023, and XYZ is now trading at $15 per share. Because you hold the $10 XYZ option, you still have the right to buy 100 shares of XYZ at $10 per share, even though the market price is $15 per share.
In this case, you could exercise the option (use it) to purchase the 100 shares for a total of $1,000. You could then immediately sell the shares for $1,500, profiting $500 instantly. Or, you could choose to keep the shares long-term.
On the other hand, if XYZ is now trading at $5 per share, you wouldn’t want to use the stock option to purchase XYZ at $10 per share, making the option worthless. The option would eventually expire unused.
Now we know what stock options actually are. But what does “stock options” mean in regards to a job offer or job listing?
Employee stock options (ESOs) are used as part of compensation packages. They may be offered in job listings or added to compensation plans as part of the negotiation process.
For instance, an employer may offer a salary of $70,000, with benefits including a health insurance plan and paid time off, and a certain allocation of stock options. All of these combined would make up the employee’s total compensation.
Importantly, ESOs can be different from stock options purchased by investors. For one, ESOs usually aren’t tradeable (meaning you can’t sell the options or buy more of them). They may also have longer expiration dates. And many companies have a vesting period before you can exercise the options. You may be required to work at the company for 5 years before you are permitted to exercise the options, for example.
In some cases, employee stock options can make up a significant portion of total compensation packages. In other cases, they may just be a small perk.
ESOs are often issued with a strike price of the current market price of the company’s stock. This means that they aren’t worth much immediately, but if the company’s stock price grows, the options can become valuable over time.
What are stock options for employees? Let’s take a look at it in practice.
For instance, let’s say you work at ABC Corp, a publicly traded technology firm. ABC stock is trading at $10 per share on the stock market.
ABC issues annual bonuses in the form of stock options. In January, you are given two contracts for ABC (for 100 shares each), with a strike price of $10 (the current market value), and an expiration date of 5 years down the line. The contracts are vested immediately.
These contracts give you the right to purchase 200 shares of ABC at $10 per share, any time within the next 5 years.
In this case, the options aren’t really worth anything on the day you receive them. You could exercise them immediately, but you would pay $10 per share (the price they currently trade at).
The value lies in the future potential value of the company. If ABC continues to grow, it could trade at $20, $30 or even $50 per share in five years from now. If ABC triples to $30 per share, those two contracts could produce a profit of $4,000 (200 shares purchased at $10 each, and then sold for $30 each).
Note that this is a simplified example. Stock option agreement details will vary by company.
The above examples assume that the company in question is publicly traded, meaning their shares trade openly on the stock market. But what if it’s a private company or early-stage start-up?
In this case, the options may only be valuable if the company eventually goes public, or is acquired by another company.
For instance, you may have the contracts to purchase 500 shares of the startup you work at. But if there is no market for the shares of that company, the contracts don’t really provide any immediate value.
But if the company goes public via an IPO or is acquired by another company, then your options could be quite valuable.
In most cases, employee stock options are not taxed until they are exercised.
That means you won’t pay any tax upfront when you’re given options. But if you eventually exercise them, you will likely owe income tax on the profits of the trade.
Note that the tax implications of ESOs do vary depending on the type of contract and other factors. Speak with your tax advisor for guidance.
In some cases, companies will offer equity in the company, rather than stock options. For instance, an employer may give employees 10 shares of stock each year as part of their salary.
In this case, you simply own the shares of the company outright. This is similar to if you had directly bought the shares as an investment.
However, there may be a vesting period during which you may not be able to sell any of the shares.
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