Takeaways
- Stock options offer employees the right to purchase stock at an exercise price.
- Stock options are offered to employees of public and private companies.
- Stock options incentivize employees to focus on long-term company growth.
- Stock options are part of an employee’s total equity compensation package.
- Stock options have two main types: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).
What Is a Stock Option?
A stock option is a contract that gives employees the right, but not the obligation, to buy shares of their company's stock at a predetermined price. This special price is called the "exercise price" or "strike price," and employees must purchase stock within a specific time frame. Stock options are issued as part of your equity compensation plan.
Startups and companies commonly offer stock options to new and existing employees. These stock options incentivize you to contribute to the company's long-term success. As the company grows and its stock price increases, you can take advantage of the success by exercising your options and selling the shares for a profit.
Read More: What Is a Publicly Traded Company?
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Stock Option Terms to Know
Understanding the various terms of equity compensation can feel like learning a new language. Here are several terms to master:
- Grant Date: Your grant date is the official date your stock option plan takes effect. Your vesting period starts on your grant date.
- Strike Price: Stock options have a strike price (or exercise price) that you must pay for each share of common stock.
- Vesting Schedule: Your vesting schedule sets the dates you can start exercising your options. Many companies set a four-year vesting period, with 25% of the award vesting annually on the grant date.
- Exercise Period: The exercise period is the amount of time you have to exercise your options from the grant date. Stock plans usually set this at 10 years from the grant date.
- Stock Option Type: There are two types of stock options: Incentive Stock Options and Non-qualified Stock Options (more on this below).
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How Stock Options Work
When a company awards options to employees, that is called a grant date. These options are subject to a vesting schedule, which outlines when employees earn the right to exercise them. Vesting schedules typically unfold over several years to encourage long-term commitment.
For instance, an employee may receive a grant with a four-year vesting schedule, where 25% of the options vest after one year (often referred to as a "cliff"), and the remaining 75% vest incrementally each month or year over the next three years.
Once an option vests, the employee can purchase the shares at the predetermined exercise price. If the stock's market value is higher than the exercise price, the employee benefits from the price difference. However, if the stock price is lower than the exercise price, the options are considered "underwater" and hold no value.
After exercising the options, employees can hold the shares for potential future growth or sell them to realize a profit.
Read Also: What Are Preferred Shares?
Two Types of Stock Options
- Incentive Stock Options (ISOs): For ISOs, the difference between your strike and exercise price is not taxed when you exercise your stock options. You are only taxed when you sell your shares. Your sale is taxed as ordinary income unless you hold the shares for a year after exercise and two years after the grant date. (Read more about How Incentive Stock Options Work).
- Non-qualified Stock Options (NSOs): For NSOs, the difference between your strike and exercise price is taxed as ordinary income when you exercise your stock options. This difference is treated as compensation is reported on your Form W-2. NSOs are more common than ISOs and don't have to meet the IRS standards of an ISO. (Read more about How Non-Qualified Stock Options Work).
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Pros of Stock Options
- Potential for Significant Gains: Employees can earn substantial profits if the company’s stock price increases significantly over time. Stock options are often sent to your online stock brokerage account. (Read more about the best online stock brokerage accounts).
- Incentivizes Performance: Stock options motivate employees to work toward the company’s success since their potential reward depends on its stock performance. (Read more about how to get the promotion you deserve).
- Low Upfront Cost for Companies: Offering stock options allows companies to attract and retain talent without immediately using cash, which is especially beneficial for startups. (Read more about how to ask for a raise).
- Tax Advantages: Incentive Stock Options (ISOs) can offer favorable tax treatment if employees hold the shares for a specific period before selling.[1] (Read more about 2024-2025 capital gains taxes).
Cons of Stock Options
- Risk of Losing Value: Your options become virtually worthless if the stock price falls below the exercise price. (Read more about tax deductions).
- Tax Implications: Exercising options can trigger taxes, even if you haven’t sold the shares, and understanding tax rules can be complex. (Read more about the 2024-2025 Federal Income Tax Brackets).
- Illiquidity: Employees may have to wait for a liquidity event, like a company trying to go public through an initial public offering, to sell their shares. (Read about accredited investors).
- Complexity: Stock options come with legal, financial, and tax challenges. Talking to a financial expert can help you clarify your equity package. (Read about the 5 times to consult with a financial planner).
Stock Option Example
Imagine an employee's equity compensation plan that includes 1,000 stock options with an exercise price of $10 per share. The options follow a four-year vesting schedule, with 25% vesting each year.
After one year, the employee vests 250 options. If the company's stock price has risen to $20 per share, the employee can exercise the 250 options by purchasing the shares at the $10 exercise price, costing $2,500. The employee could then sell the shares at $20 each, earning $5,000 and making a profit of $2,500.
However, if the stock price falls to $8 per share, the options would be underwater, and the employee would likely not exercise them. This is a risk associated with exercising stock options.
Stock Options vs. RSUs
While both stock options and Restricted Stock Units (RSUs) are forms of equity compensation, they work differently.
- Stock Options require employees to exercise their right to buy shares at a predetermined exercise price. Stock options are “in the money” when the current stock price exceeds the exercise price and “out of the money” when the current stock price is below the exercise price. They are usually subject to a four-year vesting schedule.
- Restricted Stock Units automatically convert into shares (typically common stock) once they vest. Because RSUs are shares of stock, they always retain value if the company’s stock price is above zero. They are usually subject to a four-year vesting schedule.
Here is a brief comparison of stock options and restricted stock units:
| Feature | Stock Options | RSUs |
|---|---|---|
| Ownership | Requires exercise to own shares | Automatically convert to shares upon vesting |
| Value Guarantee | Only valuable if stock price rises | Always has some value if stock price is above $0 |
| Cost to Employee | Requires payment of exercise price | No cost to receive shares |
| Tax Timing | Taxed upon exercise and/or sale | Taxed upon vesting and/or sale |
Smart Summary
Stock options are a form of deferred compensation that gives you the right, but not the obligation, to buy shares of a company's stock. They are a powerful way to financially participate in a company's growth and success. Stock options incentivize you to align your efforts with the company's long-term goals, which can lead to substantial financial rewards if the company performs well. Stock options and restricted stock units are popular forms of equity compensation.
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(1) Internal Revenue Service. Topic no. 427, Stock options. Last Accessed January 22, 2025.
(2) Internal Revenue Service. Equity (Stock) – Based Compensation Audit Technique Guide. Last Accessed January 22, 2025.
