If you work in a big company, your employers might give you the opportunity to purchase some shares belonging to this company. These are called stock options, and can become really profitable for you. However, before purchasing any shares, you should make sure you can cope with understanding stock options. Here is a guide of the process which should make everything clear.
What are stock options?
Whenever an employer offers an employee stock options, it means he gives him the right to buy some shares that belong to the company. These shares are available at a certain price, called the grant, strike, or exercise price. This price is smaller that it would have usually been.
Stock options are of two types, and the main difference between them is related to the payment of taxes. The types represent incentive stock options and non-qualified stock options. When understanding stock options, it’s vital to be familiar with the terminology. Once you know all the notions, a possible stock option offer won’t take you by surprise.
Terminology vital for understanding stock options
Here are several notions you need to know before making any decisions regarding stock options. There is the grant price, which is the price at which the employee can buy the shares. On the other hand, there is the market price, which is the price at which the shares are available on the market.
Then, there is the issue date, at which the employee receives the stock options. The vesting date is the date when you can start making use of the stock options. This is related to the exercise date, which is the date when you actually exercise the options. In the end, you have the expiration date, which is the date when the options become no longer available. You have to exercise the options by then, or you lose them.
Vesting relates to the moment when you can start exercising the options. This is decided after a strict stock option plan, and it actually means the period of time you have to be employed to the respective company before receiving the options. This is also a strategy from the employer to make you stay in the company.
However, vesting differs in each situation. For example, you can receive a vesting offer that expands over four year, and the cliff would be at one year. To translate this, it means that you have to be at least one year old in the company. After working there for one year, you get vested by 25 percent in the options.
Vesting can increase monthly as well, not only yearly. Some plans might add 1/48th of the total options every month. This way, after spending two years in the company, you’ll get vested 50 percent, and 75 percent after three years.
However, vesting doesn’t keep you tied to the company. If you want to leave it sometime before you are entitled to 100 percent of the stock options, you can only purchase the percentage associated to the time you spent in the company. For instance, leaving after two years will leave you with only 50 percent of the stock options.
Exercising the stock options means actually using them to buy shares. The purchase goes on according to the stock option plan, and you can purchase as much shares as you have been vested for. Once vesting occurs, you can exercise your options for a limited period of time. If you don’t do it within this timeframe, the options will expire.
You can exercise the options as soon as you are vested, to avoid the risk of losing them. However, you can also wait until the price of the shares is suitable for you. Although you can purchase them at a smaller price, this is still related to the market price. Knowing the difference between the two prices would let you know what profit you would make if you sold the shares.
Non-qualified stock options
This type of options is a lot more common among companies. However, they don’t offer as many advantages as the other type of options. The name means they don’t qualify for the same tax options as the others.
These tax options come at the disadvantage of the employee, as he would have to pay the taxes twice. You have to pay the first tax for the difference between the grant price and the market price. Then, after selling the shares you’ve purchased, you pay taxes on the gains. This is related to the time you’ve waited before selling.
Incentive stock options
In this type of options, you don’t have to pay for the difference between the grant price and the market price. The only mandatory tax is the one on your gain. However, there is one condition. You can keep this tax reduction as long as the value of the options stays below a limit of $100,000.
This limit is the value of the shares on the market when they were granted to you. However, the tax calculations will pay attention to the time of vesting. Here’s a practical example to make everything clear.
Let’s say the stock option you have received has a total value of $120,000 on the market. At a first look, it would appear the tax deduction won’t apply to it. However, your vesting period might be of four years. Therefore, you can only exercise $30,000 per year of the total value. This means the tax deduction remains available.
Incentive stock options also have some other restrictions. You have to wait for a certain period of time before selling the shares. Once you get the grant for the stock options, you have to wait two years before selling. Also, once you get to exercise the option, you have to wait for another year.
Understanding stock options is vital if you work in a big company, as you might receive them anytime. You have to be familiar with the entire process and the terminology, so that you can make the necessary decisions regarding your shares. This way, you’ll now how to invest or when to sell your shares, and get the biggest benefits out of it.