Stock options are a type of alternative compensation that some companies, including many startups, offer as part of their compensation package for employees. Employees can potentially come on board at a lower salary in exchange for the possibility of a big payday later on. If you’ve been offered options as part of a compensation package, or if you’re considering exercising and selling those options, it’s important to know how they work.

A financial advisor can help you create a financial plan for your stock options or any other investments.

What Are Stock Options?

Stock options are a form of compensation. Companies can grant them to employees, contractors, consultants and investors. These options, which are contracts, give an employee the right to buy, or exercise, a set number of shares of the company stock at a preset price, also known as the grant price.

This offer doesn’t last forever, though. You have a set amount of time to exercise your options before they expire. Your employer might also require that you exercise your options within a period of time after leaving the company.

The number of options that a company will grant its employees varies, depending on the company. It will also depend on the seniority and special skills of the employee. Investors and other stakeholders have to sign off before any employee can receive stock options.

Understanding Stock Option Granting and Vesting

Stock options can be an exciting part of your compensation package, but it’s important to understand how they work. Let’s break down the basics with an example.

How Stock Option Granting Works

Say you’ve landed a job at a startup, and part of your compensation includes stock options for 20,000 shares of the company’s stock. To formalize this, you and the company sign a contract – usually part of your employment agreement – that outlines the terms of the stock options. This contract will include the grant date, which is the starting point for the vesting process.

What Does Vesting Mean?

When a stock option vests, it becomes available for you to exercise, meaning you can buy the stock at a predetermined price. However, you don’t receive all your options immediately. Instead, they vest over time during a vesting period.

In this example, let’s say your options have a four-year vesting period with a one-year “cliff.” A four-year vesting period means it will take four years before you have the right to exercise all 20,000 options. The one-year cliff means you must stay with the company for at least a year before receiving any options. If you leave before that year is up, you forfeit all the options.

The Vesting Schedule

Once you pass the one-year cliff, you’ll receive your first 5,000 options (one-quarter of the total 20,000). After that, the remaining 15,000 options will vest gradually over the next three years. In this case, the vesting schedule might grant you approximately 416 options per month (1/36 of the remaining options) until all 20,000 have vested.

For example:

• Year 1: No options vest until you reach the one-year cliff.
• Year 2: You’ve vested 10,000 options (the first 5,000 after the cliff, plus another 5,000 for the second year).
• Year 4: All 20,000 options are vested and available to exercise.

Stock options can be a powerful financial incentive, but understanding the details of your vesting schedule and commitment requirements is key. Be sure to review your contract carefully and consult a financial advisor if needed to fully grasp the implications.

How to Calculate What Your Stock Options are Worth

The value of your stock options can be difficult to calculate if the company is not publicly traded. There might be a lot of valuation numbers thrown out surrounding what a stock might be worth. But if there isn’t a monetary event, such as an IPO or a sale of the business, then there isn’t a concrete way to determine what each share price is actually worth.

Some businesses will receive a valuation that you can use to calculate what your stock options might be worth. However, these numbers are speculative, and can’t be relied on. You’ll also have to know the number of shares that are available, in all, for the company in order to determine the share price.

If you already know the share price then the calculation becomes easy to make. Every stock option will provide a strike price, which is the value you must purchase your shares at. If your strike price is $10 per share and the current share price is $20 then your shares are worth $10 per share ($20 – $10). Then you can multiply the $10 per share value by the number of share options you’ve been granted and you can come to the total value of your stock options.

How to Exercise Stock Options

Once your stock options vest, you gain the ability to exercise them – essentially, buying shares of your company’s stock. Until you exercise, the options hold no real value. The price you pay to exercise, known as the grant price, strike price or exercise price, is determined in the initial contract you signed. This price remains unchanged, regardless of how the company performs.

How Exercising Stock Options Works

For example, let’s say you’ve completed your four-year vesting period and now hold 20,000 stock options with an exercise price of $1 per share. To exercise all of your options, you would pay $20,000 (20,000 shares x $1 per share). Once exercised, you own the stock outright. From there, you can choose to sell the shares immediately or hold onto them in hopes that the stock price will increase further.

Keep in mind that exercising stock options comes with additional costs, including commissions, fees and taxes.

Alternatives to Paying Out of Pocket

If you don’t have the cash to cover the cost of exercising your options, there are alternative strategies available:

• Exercise-and-Sell Transaction: In this method, you buy the shares and immediately sell them. The brokerage facilitates the transaction by covering the upfront cost with proceeds from the sale. This eliminates the need for you to use your own funds.
• Exercise-and-Sell-to-Cover Transaction: Here, you sell just enough shares to cover the cost of purchasing them and retain the remaining shares in your portfolio.

Be Aware of Expiration Dates

Stock options come with an expiration date, which is outlined in your contract. Common expiration periods include 10 years from the grant date or 90 days after leaving the company. Be sure to exercise your options before they expire to avoid losing them.

When You Should Exercise Stock Options

When and how you should exercise your stock options will depend on a number of factors. First, you’ll likely want to wait until the company goes public, assuming it will. If you don’t wait, and your company doesn’t go public, your shares may become worth less than you paid – or even worthless.

Second, once your company has its IPO, you’ll want to exercise your options only when the market price of the stock rises above your exercise price. For example, let’s say you have an exercise price of $2 per share. If the market price is $1, it doesn’t make sense to exercise your options just then. You would be better off buying on the market.

On the other hand, if the market price is $3 per share, you would make money from exercising your options and selling. 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. So why not wait until the market price is where you would sell? That way, you’ll buy and sell – and pocket a profit without being out any money for an extended period of time.

That said, if all indicators point to a climbing stock price and you can afford to hold your shares for at least a year, you may want to exercise your options now. That way, you’ll pay less in capital gains tax and on income tax (see below). Also, if your time period to exercise is about to expire, you may want to exercise your options to lock in your discounted price. But if you’re at all worried about losing money, you should consult an investment professional.

Stock Options and Taxes

You will usually need to pay taxes when you exercise or sell stock options. What you pay will depend on what kind of options you have and how long you wait between exercising and selling.

For starters, it’s important to note that there are two types of stock options:

• Non-qualified stock options (NQSOs) are the most common. They do not receive special tax treatment from the federal government.
• Incentive stock options (ISOs), which are given to executives, do receive special tax treatment.

The table below breaks down key tax differences between NQSOs and ISOs:

Taxed as long-term capital gains if shares are sold one year after the exercise date and two years after the grant date. Must pay regular income taxes if sold before then.

Non-Qualified Stock Options (NQSOs) vs. Incentive Stock Options (ISOs)

With NQSOs, the federal government taxes them as regular income. The company granting you the stock will report your income on your W-2. The amount of income reported will depend on the bargain element (also called the compensation element). This is the difference between a stock’s market value and your exercise price.

If you exercise 10,000 options at an exercise price of $1 each, but those shares cost $2 each on the market, the bargain element is $10,000 ($1 price difference x 10,000 shares). That $10,000 goes on your W-2 as ordinary income.

When you decide to sell your shares, you will have to pay taxes based on how long you held them. If you exercise options and then sell the shares within one year of the exercise date, you will report the transaction as a short-term capital gain. This type of capital gain is subject to the regular federal income tax rates.

If you sell your shares after one year of exercise, the sale falls under the category of long-term capital gains. The taxes on long-term capital gains are lower than the regular rates. This means you could save money on taxes by holding your shares for at least one year.

ISOs operate a bit differently. You do not pay taxes when you exercise ISOs. However, the amount of the bargain element may trigger the alternative minimum tax (AMT). This phases out income exemptions targeted for low- and middle-income taxpayers. So if your income is over $85,700 for individuals in 2024 (and more than $133,300 for married couples filing jointly or qualifying widowers), you could be subject to the AMT.

When you sell shares from ISO options, you will need to pay taxes on that sale. If you sell the shares as soon as you exercise them, the bargain element is regular income. If you hold the stock for at least one year after exercise AND you don’t sell the shares until at least two years after the grant date, the tax rates you pay are the long-term capital gains rates.

Other Types of Employee Equity Compensation

There are multiple ways that employees can be compensated that are similar to receiving direct stock options. These range from a grant, which provides the right to buy the stock once certain criteria have been met, to full plans that give the right to buy stock to every employee. The main types of employee stock options or ways to purchase stock outside of being awarded options directly are:

• Restricted Stock Unit Grants: This is the most popular type of employee stock plan for many startups. Restricted stock units (RSUs) provide several of the features described above. These include a vesting period of how long the employee must work for the company to access a certain amount of stock options. Once the criteria have been met, then the employee has the stipulated amount of time in the grant documentation to exercise their options.
• Employee Stock Purchase Plans: A full employee stock purchase plan enables certain levels of employees, by job title, or all employees to purchase stock at the company. This can often include a discount to employees on the value of the stock at the time of purchase in order to provide a benefit to employees. An ESOP would be an example of an employee stock purchase plan.
• Phantom Stock: Another way employees can benefit from the increase in stock value for the business is to receive phantom stock. This is essentially a bonus for what a certain number of shares would be worth at a specific point in time. There is no ownership transfer or exercising of shares in this scenario. Sometimes phantom stock can be converted into real shares instead of receiving a cash bonus.

Bottom Line

Stock options are becoming a more common way for companies to attract and keep employees. They’re not as straightforward as a paycheck, but they have the potential of a big payday. Option terms are specific to the individual company through a contract you must sign. You should familiarize yourself with the terms in your contract. It will tell you how many options the company is granting and the length of the vesting period.

The contract will also have the grant price, which is what you will pay when you exercise those options. How and when you exercise options will depend on the price of the shares. There are also income tax considerations. This means the promise of lower tax rates if you hold onto your shares for at least one year.

Tips for Selling Your Employee Stock Options

• Many factors could affect the best time to sell a stock option. A financial advisor can help you figure this out with a financial plan for your investments. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area. You can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Exercising and selling will impact your taxes. SmartAsset’s free income tax calculator can help you see how the additional income will change your tax bill. And if you’ve held your stock for a long time, our capital gains tax calculator can show you the tax impact of selling.

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