The price that you will pay for those options is set in the contract that you signed when you started. You may hear people refer to this price as the grant price, strike price or exercise price. No matter how well or poorly the company does, this price will not change. You can also hold it and hope that the stock price will go up more. Note that you will also have to pay any commissions, fees and taxes that come with exercising and selling your options.
There are also some ways to exercise without having to put up the cash to buy all of your options. For example, you can make an exercise-and-sell transaction. To do this, you will purchase your options and immediately sell them.
Rather than having to use your own money to exercise, the brokerage handling the sale will effectively front you the money, using the money made from the sale in order to cover what it costs you to buy the shares. Another way to exercise is through the exercise-and-sell-to-cover transaction. With this strategy, you sell just enough shares to cover your purchase of the shares, and hold the rest. You can find this in your contract. When and how you should exercise your stock options will depend on a number of factors.
You would be better off buying on the market. But if the price is on the rise, you may want to wait on exercising your options. Once you exercise them, your money is sunk in those shares. In this article, we provide an overview of some of the key considerations in making stock option grants: who gets an option, the size of the option, vesting terms and pricing.
After the formation of a startup and prior to any significant financing, companies should and often do consider establishing a pool for providing equity grants to initial employees, consultants, advisors and directors. For example, if the founders hold 9 million shares, a pool of 1 million shares might be set aside for equity grants, including stock options, to be made between formation and the anticipated time of a first financing.
In this case, the pool would be 10 percent of the shares expected to be issued or granted under options and other equity awards prior to the financing. There is no magic to 10 percent; the number should be based upon what the founders think they need in their particular situation. However, as a practical matter, some amount between 5 percent and 20 percent would be typical. See our article with more considerations about sizing an option pool.
A new pool is often created as part of the negotiation for the first substantial financing, typically to provide for enough shares to cover the estimated number of option grants between the first and the second financing.
A typical pool following a Series A financing would be of around 15 percent of the number of post-financing shares outstanding or reserved. Of course, the shares of stock for the pool and for stock option grants should be for common stock, as there are tax rules that make it very difficult to grant stock options for preferred shares or stock that has distribution preferences.
For employees, the key benefits of any type of equity compensation plan are:. The benefits of an equity compensation plan to employers are:.
In terms of stock options, there are two main types:. There are two key parties in the ESO, the grantee employee and grantor employer. The grantee—also known as the optionee—can be an executive or an employee, while the grantor is the company that employs the grantee. The grantee is given equity compensation in the form of ESOs, usually with certain restrictions, one of the most important of which is the vesting period.
The vesting period is the length of time that an employee must wait in order to be able to exercise their ESOs. Why does the employee need to wait? Because it gives the employee an incentive to perform well and stay with the company. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant. Note that the stock may not be fully vested when purchased with an option in certain cases, despite exercise of the stock options, as the company may not want to run the risk of employees making a quick gain by exercising their options and immediately selling their shares and subsequently leaving the company.
If you have received an options grant, you must carefully go through your company's stock options plan, as well as the options agreement, to determine the rights available and restrictions applied to employees. The options agreement will provide the key details of your option grant such as the vesting schedule, how the ESOs will vest, shares represented by the grant, and the strike price.
If you are a key employee or executive, it may be possible to negotiate certain aspects of the options agreement, such as a vesting schedule where the shares vest faster, or a lower exercise price. It may also be worthwhile to discuss the options agreement with your financial planner or wealth manager before you sign on the dotted line. ESOs typically vest in chunks over time at predetermined dates, as set out in the vesting schedule.
As mentioned earlier, we had assumed that the ESOs have a term of 10 years. This means that after 10 years, you would no longer have the right to buy shares. Therefore, the ESOs must be exercised before the year period counting from the date of the option grant is up. It should be emphasized that the record price for the shares is the exercise price or strike price specified in the options agreement, regardless of the actual market price of the stock.
In some ESO agreements, a company may offer a reload option. A reload option is a nice provision to take advantage of. We now arrive at the ESO spread. As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread.
The following points need to be borne in mind with regard to ESO taxation:. This spread is taxed as ordinary income in your hands in the year of exercise, even if you do not sell the shares. This aspect can give rise to the risk of a huge tax liability, if you continue to hold the stock and it plummets in value. The ability to buy shares at a significant discount to the current market price a bargain price, in other words is viewed by the IRS as part of the total compensation package provided to you by your employer, and is therefore taxed at your income tax rate.
Thus, even if you do not sell the shares acquired pursuant to your ESO exercise, you trigger a tax liability at the time of exercise. The value of an option consists of intrinsic value and time value. Time value depends on the amount of time remaining until expiration the date when the ESOs expire and several other variables. Given that most ESOs have a stated expiration date of up to 10 years from the date of option grant, their time value can be quite significant. While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them.
To calculate the time value for your ESOs, you would have to use a theoretical pricing model like the well-known Black-Scholes option pricing model to compute the fair value of your ESOs. You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO.
From there, it is a simple exercise to calculate time value, as can be seen below. The exercise of an ESO will capture intrinsic value but usually gives up time value assuming there is any left , resulting in a potentially large hidden opportunity cost.
The value of your ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, time to expiration, and above all, volatility. Consider a situation where your ESOs are out of the money i.
It would be illogical to exercise your ESOs in this scenario for two reasons. The biggest and most obvious difference between ESOs and listed options is that ESOs are not traded on an exchange, and hence do not have the many benefits of exchange-traded options.
Exchange-traded options, especially on the biggest stock, have a great deal of liquidity and trade frequently, so it is easy to estimate the value of an option portfolio.
Not so with your ESOs, whose value is not as easy to ascertain, because there is no market price reference point. Many ESOs are granted with a term of 10 years, but there are virtually no options that trade for that length of time. LEAPs long-term equity anticipation securities are among the longest-dated options available, but even they only go two years out, which would only help if your ESOs have two years or less to expiration.
Option pricing models are therefore crucial for you to know the value of your ESOs. Your employer is required—on the options grant date—to specify a theoretical price of your ESOs in your options agreement.
Be sure to request this information from your company, and also find out how the value of your ESOs has been determined. Option prices can vary widely, depending on the assumptions made in the input variables. For example, your employer may make certain assumptions about expected length of employment and estimated holding period before exercise, which could shorten the time to expiration.
With listed options, on the other hand, the time to expiration is specified and cannot be arbitrarily changed. Assumptions about volatility can also have a significant impact on option prices.
If your company assumes lower than normal levels of volatility, your ESOs would be priced lower. Listed options have standardized contract terms with regard to number of shares underlying an option contract, expiration date, etc. This uniformity makes it easy to trade options on any optionable stock, whether it is Apple or Google or Qualcomm.
Then, diversify the new shares of RSUs that vest in other words, sell them and use the money to invest in other stocks. This will have minimal tax consequence. Continue to manage future RSUs and other equity compensation similarly. That typically involves having an investment portfolio that is appropriate for each major financial goal you have and an emergency savings account to cover basic needs for three to 12 months.
There are multiple ways to diversify your portfolio, but some are more tax-efficient than others. For instance, selling recently vested RSUs or recently exercised non-restricted stock options NSOs will likely have minimal tax consequence. If you hold exercised incentive stock options ISOs , it would be beneficial to sell your stock options that meet the special holding requirement i.
Stock options with a special holding requirement are taxed as long-term capital gains, and the tax rates for long-term capital gains are lower than regular income tax rates. You contribute to the plan through payroll deductions — similar to how you contribute to a company k — which then accumulates between the offer date and the purchase date. Talk to an accountant or financial planner specializing in equity compensation if you need help diversifying your portfolio while minimizing taxes. Consider investing the proceeds from your equity compensation by funding tax-advantaged accounts, which are savings accounts that are exempt from taxes today or in the future or that offer other tax benefits.
For example, you could use the money you make to cover your ongoing cash needs to max out your k or Roth k account. Traditional k and IRA accounts provide a tax benefit upfront, while the Roth versions provide a tax benefit at withdrawal, and both provide a tax benefit while the account is growing.
If you are eligible for a health savings account HSA , consider using proceeds from your equity compensation to contribute to this. HSAs provide a tax benefit upfront and at the time of withdrawal, as long as they are used for a wide array of qualified medical expenses. But if your company offers equity compensation as part of its benefits package, participating could lead to amazing financial returns.
Take the time to put in the necessary research so you can participate with confidence. If you are seeking more specific financial advice, it is best to consult a tax, legal , and accounting advisor who can provide guidance on your unique situation.
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