Employee Stock Options: What You Should Know Before Exercising

By TRG Advisors on September 13, 2022

Stock options are an alternative type of equity compensation commonly offered by startup companies that gives employees the option to purchase shares of their employer’s stock. While these options may not have a ton of value in the early stages of a company’s life cycle, they encourage buy-in and have the potential to provide a significant payout down the line should the company perform well. For employees, the decision to cash out your options entails balancing your immediate need for money with your desire to maximize your earnings in the long-term—something that’s often easier said than done.

The choice of when to exercise ones stock options belongs to the individual; but to help you determine what the right decision is for you, let’s take a look at some of the basics of employee stock options.

What Are Employee Stock Options?

Employee stock options are a form of equity compensation, or company stake, granted by employers. Rather than actual shares, these contracts give workers the right to buy a set number of shares of company stock at a fixed grant price, a process known as “exercising” the option. Typically, the grant price is based on the market value of the company at the time of signing, but it can be lower or higher than that value depending on the terms outlined in the employee stock option agreement.

Stock options can be an excellent opportunity for employees to invest in the companies they work for and ultimately earn more money, but they don’t last forever. There is a finite time frame, or exercise period, during which you can purchase stock using your options. The exercise period is specified by your employer within the contract and they tend to last a maximum of 10 years. This means you can’t hold onto them indefinitely; you’ll have to make a plan for what to do with them.

Within this exercise period, employees may be further restricted when it comes to exchanging their options for hard stock. The “vesting period” refers to the minimum amount of time an employee must work with the company before they’re able to exercise their employee stock options. Vesting is a tool that employers use to ensure that employees are bought in to the firm’s goals and committed to remaining with the firm for the medium to long term, often a period of three to five years. Additionally, the option agreement might require that the market value of the stock rise above a certain threshold, known as the call option exercise price.

Different Types of Employee Stock Options

There are two primary types of employee stock options that you are likely to see:

non-qualified stock options (NSOs) and incentive stock options (ISOs). Similar to stock options, we’ll also review restricted stock units (RSUs), another common type of equity compensation. They’re treated differently for tax purposes and which type of grant you receive will bear important implications for how you deploy them.

Non-Qualified Stock Options (NSOs)

A company can grant NSOs to employees at all levels, including board members and consultants. The IRS treats the exercise of these options as ordinary taxable income. As such, NSOs are taxed twice—once when you exercise them and again when you sell them. The proceeds are taxed based on the difference between the call option exercise price and the current fair market price.

To illustrate, let’s say your exercise price is set at $10. A few years later, the company is doing well and the current market value is $25 per share. If you were to sell your stock at this point, you’d have to pay taxes on the $15 difference in the form of capital gains. NSOs don’t offer their owners the same tax benefits as ISOs, which can make the former a less valuable option than the latter.

Incentive Stock Options (ISOs)

ISOs are a corporate benefit that is generally exclusive to the top levels of the company, including management, executives, and certain key employees. Unlike NSOs, the exercise of these options isn’t considered a taxable event. The IRS does still treat the proceeds from ISOs as long-term capital gains, so the only taxes you pay are when you decide to sell your shares.

To receive the preferential tax treatment of capital gains, you must hold your ISOs for a minimum of one year from the exercise date and two years from the date they were granted. If you sell during either of these time periods, it’s considered a disqualifying disposition and the proceeds are taxed as ordinary income.

Restricted Stock Units (RSUs)

An RSU is a company’s promise to give an employee shares of stock, in the future. Unlike stock options, you don’t have to buy them. The grants are “restricted” because they are subject to a vesting schedule, which maybe be based on long of employment or performance goals.

RSUs are taxable – with taxes withheld similarly to wages – as of the date the RSU vests and the actual stock is transferred to you. Any gain from that date forward is taxed as a short- or long-term capital gain, depending on how long you own the newly issued shares of stock. Some companies withhold a portion of the RSUs to help employees pay the corresponding taxes that will be owed when they are vested. However, a company may also give employees the option of paying taxes out of pocket so they retain all vested RSUs.

Things to Consider When Exercising Your Options

Taking a strategic approach to handling your employee stock options can help you maximize your earnings while minimizing your tax burden. Here are a few things you should consider before exercising your options:

• Timing:
  • This is likely to be the most consequential factor as it pertains to exercising. Because you’re looking to exercise when the market value of your employer’s stock is highest, waiting for the company to go public can be a wise decision. Along the same lines, if your company is going through a rough patch that adversely affects its valuation, it may benefit you to hold out until things rebound. The key is making sure that the market value of the company’s shares is higher than your exercise price, otherwise you could be better off just buying on the stock market.
• Taxation:
  • Whether you’ve got an NSO, an ISO or an RSU, taxes are unavoidable when you eventually sell your stock, although ISOs generally entail a lower total tax obligation than NSOs do. The amount you pay in capital gains taxes will depend on what type of options you have and how long you hold them between exercising and selling. It’ll also be a function of which income tax bracket you fall into at the time of sale.
• Company Outlook:
  • You should also consider what happens to your stock if the company gets acquired, shuttered, or otherwise impacted by a significant change of course. Should the company merge with another or cease to exist entirely, terms will be laid out for how your options are handled. These events will impact the value of your options, so it’s important that you plan ahead as well as you’re able to.

Ultimately, deciding when to exercise or sell your employee stock options will depend on your individual circumstances, company performance, and which type of options you receive. To learn more about employee stock options, how your options impact your financial plan or for help determining the right course of action, reach out to the team today.