How Do Stock Options Work: Find Out Here
Whenever a big and fast growing firm goes public, a lot of its employees also get a lot richer. The secret behind that is the power of stock options. Take the example of Pinterest, when it went public, a lot of its employees ended up getting a lot of windfall gains because of their stock options. When the IPO was launched, CEO Ben Silbermann’s was estimated to be $1.6 billion. It was found out later that he could’ve made $150 million more if he handled his 31.2 million options better. As a result of that, he faced high short term capital gains tax instead of long-term capital gains tax. That clearly shows the importance of stock options. Let’s find out more about them now.
How Do Stock Options Work: Things to Know
What Are Stock Options?
Stock options are one of the most popular forms of equity compensation. A option gives the holder the right to purchase a selected number of shares of company stock at a pre-set price, referred to as the “exercise” or “strike price,” for a fixed period of time, usually following a predetermined waiting period, called the “vesting period.” Most vesting periods last three to five years, with a particular percentage of options vesting (which means you’ve “earned” your shares, though you continue to exercise i.e., purchase them).
What is the biggest advantage of stock options?
One of the biggest and most obvious advantages of options is leverage. Compared to other kinds of equity compensation, there are more options per grant. This results in a significant upside potential. However, there is always some risk associated with them, so be mindful of that.
How Do Stock Options Work?
Stock options are a common tool for attracting prospective employees and to retain current employees. They inflate the employee’s compensation package, without the firm paying out actual cash.
The incentive of giving stock options to a prospective employee is the possibility of owning stock of the corporate at a reduced rate compared to purchasing the stock on the open market.
The retention of employees who are granted stock options occurs through the process of vesting. Vesting helps employers encourage employees to remain through the vesting period to get the shares granted to them. Your options don’t belong to you until you’ve worked with the company for the given vesting period.
For example, assume you’ve been granted 10,000 shares with a four-year vesting schedule at 2,500 shares at the top of every year. This means you’ve got to remain for a minimum of one full year so as to exercise the primary 2,500 shares and must stay beyond the fourth year in order to have the ability to exercise all the 10,000 shares. In order to receive your full grant, you’ll be required to stick with your company till the completion of the vesting period.
Exercising and selling Stock Options
Options can’t be exercised until they are vested. There could also be some agreements which will accelerate the vesting schedule (e.g., within the event of an acquisition), but these are rare. And there also are deadlines deciding when you can exercise or access your options – they typically expire after 10 years from the date of grant. In case your company pays you off prior to your options being vested or some other firm acquires your company, your unvested options will be lost.
Once you’re able to exercise your options, you sometimes have several ways of doing so:
- Cash Payment – you’ll come up with the cash to exercise the choices. This would include covering any costs to accumulate the stock.
- Cashless Exercise – Some employers allow you to exercise your options and your employer sells only enough of the stock to hide the prices you incurred to accumulate the stock.
You also have the option to sell all the shares exercised by you at the prevailing market price. This means that you will avoid being exposed to stock price volatility and you will not be required to come up with upfront cash for any transaction costs once you exercise. However, the tax implications might not be beneficial, counting on your unique situation.
How to Calculate Your Stock Options’ Worth?
There is a relatively simple way to determine what your stock options are worth: if the stock is worth $25/share, and your strike price is $20, then your options will be worth $5 each.
If your company is pre-IPO, it tends to be difficult to work out exactly what your stock options could be worth. How much your options could be worth in the future depends on two things: the strike price, and the future performance of the stock (what will the stock be worth per share when the corporate goes public or there’s a purchase event, and beyond?).
Another important thing to notice when evaluating the worth of your options — options have little value unless the market price is more than the exercise price, which creates a bit more risk than other forms of equity. If you exercise your options and then the price decreases, you lose both the cash you will get from exercising the shares as well as money through additional taxes.
How Are Stock Options Taxed?
There are two sorts of stock options – ISOs (Incentive Stock Options) and NSOs (non-qualifies or nonstatutory stock options). The main difference is how they are taxed. With NSOs, you incur a bill once you exercise your options. The difference between the fair market value (FMV) and the exercise price is subject to regular tax for the year. All additional gains are taxed under long-term capital gains when you sell the shares.
ISOs, on the opposite hand, aren’t taxed right at exercise. Instead, you’re taxed on ISOs once you eventually sell your shares. However, to qualify for the treatment as capital gains tax on a typical income tax return, you would want to hold the shares two years from grant and one year from exercise (if you don’t meet this requirement, then the sale will be treated as a disqualifying disposition). If these dates are met and the value of the stock increases consequently, you’ll only owe long-term capital gains tax once you sell.
Keep in mind, tax treatments of options are often complex. When you plan to exercise and sell determines the money you’ll make with your stock options. You can also get in touch with a financial advisor or a tax professional for further clarification and guidance.
Warren Buffet on Stock Options
In his 1985 letters to shareholders, legendary investor Warren Buffet discussed the topic of stock options in great detail. According to Buffet, stock options were good rewards for talented and value adding managers. He added that if they were dished out fairly, they could serve as very appropriate remuneration.
Warren Buffet observed that many managers in U.S. corporations applied a double standard to options. The extreme case would be the ten-year fixed-price options on all or a portion of the business granted to management. It was unthinkable for the manager to grant long-term options on the business that added more money on its capital base regularly. Warren Buffet said: “Managers regularly engineer 10-year, fixed-price options for themselves and associates that, first, totally ignore the fact that retained earnings automatically build value, and, second, ignore the carrying cost of capital. As a result, these managers end up profiting much as they would have had they had an option on the savings account that was automatically building up in value.”
The stock option is often thought of as a reward which is supposed to place managers and shareholders on the same boat. In other words, it gives managers the option to “truly walk in the shoes of the owners.” However, according to Buffett, those financial boats were far different. The stock option has two main advantages for the managers that the shareholders of the business can’t have. The first advantage comes in the form of capital cost; no owner can escape from the burden of capital cost. However, a fixed-price option holder doesn’t have any capital costs whatsoever. The second is the downsize risk. Shareholders have to bear the downsize risk, but the managers don’t. “In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership,” Buffett wrote. For Buffett, it is like a lottery ticket: He would feel happy to accept the lottery ticket as a gift, but he would never buy one.
How do Stock Options Work: Conclusion?
When it comes to any kind of employee compensation, having a comprehensive and thorough understanding of your stock options is key. You need to calculate what they are worth and how they can fit into your diversified portfolio. When it comes to stock options, you have to speculate a little bit. So, it’s highly advisable to take the help of a financial advisor while analysing your stock options and what to do with them.