How Employee Stock Options Work: Explanation and Examples

Stock options are a common type of alternative compensation. Some companies, including many startups, offer stock options as part of their compensation package for employees. Employees may be more willing to 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 specified period after leaving the company.

The number of options a company grants its employees varies by company. It also often depends on the employee’s seniority and special skills.

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.

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. 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. This 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

After the one-year cliff, you’ll receive your first 5,000 options, which is 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. However, understanding the details of your vesting schedule and commitment requirements is key.

Be sure to review your contract carefully and consult a financial advisor to fully grasp the implications.

What Happens to Your Stock Options if You Leave Your Company

Changing jobs can have a significant effect on your stock options.

While vested options generally remain available after you leave, they often do not remain exercisable indefinitely. The amount of time you have depends on your stock option agreement.

Many companies require former employees to exercise vested options within a specified period after their employment ends. If that deadline passes, the options generally expire, even if they would have been valuable. Unvested options, meanwhile, are typically forfeited when you leave unless your plan provides otherwise.

Before deciding whether to exercise, consider the cost of purchasing the shares and the company’s current valuation. Also assess whether there is a realistic opportunity to sell the stock. For employees of private companies, exercising options may require a substantial cash payment even though there is no public market for the shares.

Before leaving your employer, review your stock option agreement carefully. Understanding how many options have vested, when they expire and how long you have to exercise them can help you avoid losing compensation that may have accumulated over several years.

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.

However, 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 upon. You must also know the total number of shares available for the company to determine the share price.

If you already know the share price, the calculation becomes easy to make. Every stock option has a strike price, which is the price at which you must purchase your shares.

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 does not change, regardless of how the company performs.

How Exercising Stock Options Works

For example, let’s say you have 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 will pay $20,000 (20,000 shares x $1 per share). Once exercised, you own the stock outright as part of your investment portfolio. 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 have an expiration date, as 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 depends on several 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 company’s stock price is $1, it doesn’t make sense to exercise your options at that price. 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 by exercising your options and selling them.

However, if the price is rising, you may want to wait before 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? This 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. This way, you’ll pay less in both capital gains tax and income tax. Also, if your exercise period is about to expire, you may want to exercise your options to lock in your discounted price.

For help, consider consulting a financial advisor.

Stock Options and Taxes

You usually need to pay taxes when you exercise or sell stock options. How much you pay will depend on the options you have and how long you wait between exercising and selling.

There are two types of stock options.

Non-qualified stock options (NQSOs) are the most common.¹ 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.¹

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

Tax Situation	NQSOs	ISOs
Exercise Date Taxes	Taxed as regular income. Must pay the difference between the stock’s market value and the exercise price.	Do not have to pay taxes on the exercise date. Differences between the stock’s market value and the exercise price could trigger the alternative minimum tax (AMT).
Sale Date Taxes	Must pay short-term capital gains on shares sold within one year of the exercise date, and long-term capital gains on shares sold after at least one year.	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.

NQSOs

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 you report 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 qualifies as 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

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).² This phases out income exemptions targeted for low- and middle-income taxpayers. If your income is over $90,100 for individuals in 2026, or more than $140,200 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 don’t sell the shares until at least two years after the grant date, the tax rate you pay is the long-term capital gains rate.

Other Types of Employee Equity Compensation

There are other types of compensation similar to receiving direct stock options. These range from a grant, which provides the right to buy stock after meeting certain criteria, to full plans that grant every employee the right to buy stock.

There are a few main types of employee stock options, as well as ways to purchase stock beyond being awarded options directly.

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, the employee has the stipulated time in the grant documentation to exercise their options.

Employee Stock Purchase Plans

A full employee stock purchase plan enables certain employees or all employees to purchase company stock. This often includes a discount on the stock’s value at the time of purchase to benefit employees.

An Employee Stock Ownership Plan (ESOP) is one example of an employee stock purchase plan.

Phantom Stock

Another way employees can benefit from the business’s stock price increase is by receiving phantom stock. This is essentially a bonus equal to the value of a certain number of shares at a specific point in time. There is no ownership transfer or exercising of shares in this scenario.

Sometimes, phantom equity can be converted into real shares instead of receiving a cash bonus.

Tax Planning and Exit Strategies for Stock Options

Managing stock options effectively involves more than knowing how and when to exercise them.

Tax treatment can vary depending on the type of option, the timing of exercise and how long you hold the shares. Planning ahead for these considerations can help you decide when to exercise and sell in ways that align with your cash flow and tax strategy.

Timing and holding periods. The timing of an exercise can affect both your taxable income and capital gains. Some employees gradually exercise over time to spread out taxable income, while others wait until a liquidity event, such as an IPO or acquisition.
Cash flow considerations. Exercising options may require significant funds, especially if the strike price applies to thousands of shares. If cash flow is limited, partial exercise or using a sell-to-cover transaction may be preferable.
Exit events and liquidity. For private companies, liquidity events such as an IPO or a merger determine when you can sell your shares. It is important to review the company’s lock-up period and trading restrictions after an IPO. For acquisitions, review the conversion terms to understand how your unexercised or vested options are handled.
Tax recordkeeping. Keep documentation for all grant, exercise and sale transactions, including grant letters, Form 3921 (for ISOs)³ and brokerage statements. These records are used to report income and capital gains correctly.
Professional guidance. Because of the complex interaction between option type, timing and income tax rules, many employees consult tax professionals before exercising large grants or when planning for a liquidity event.

Bottom Line

An employee accepts a job offer, with stock options as part of the compensation plan.

Stock options are becoming a common way for companies to attract and keep employees. While not as straightforward as a paycheck, they have the potential of a big payday. Option terms are specific to the individual company and set out in a contract, so you’ll need to familiarize yourself with the terms of the agreement. How and when you exercise options will depend on several factors, including the price of the shares and income tax considerations.

A financial advisor can provide insight on how and when to best use your stock options.

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 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.