Employee Equity Explained: Stock Options
Today, we are continuing our series on Employee Equity Explained by discussing stock options specifically.
Stock options are contracts that allow an employee to buy shares (this is called “exercising” the option) at a fixed price. Options are different than receiving stock because an option is exactly as it sounds; it’s an option to buy stock upon certain conditions being met, such as vesting (discussed below).
There are two standard types of stock options: Incentive Stock Options (“ISOs”) and Nonstatutory Stock Options (“NSOs”).
ISOs provide the recipient with certain tax benefits but they can only be provided to employees of the company, not independent contractors or non-employee board members. Additionally, only $100,000 in ISOs can be exercisable in any given year. NSOs on the other hand can be provided to non-employees such as independent contractors, advisors, etc. Joe Wallin has a great chart comparing ISOs and NSOs at his former Startup Law Blog.
Stock options provide you with the option to purchase stock at fixed price per share called a strike price or exercise price. Typically, the strike price is based on the fair market value of the shares at the time they are given to you, and the expectation and hope is that the shares will be worth much more in the future when you exercise them.
Stock options are generally subject to specific conditions and almost always are subject to a vesting schedule. Typically, you will only vest in your shares while you work for the company and most tech companies issue stock options with 4 year vesting schedules with a 1-year cliff. A 1-year cliff means that if you only worked for the company for 10 months, you would not vest in any of your shares. However, if you worked for 12 months then you would vest in a portion (say 25%) of your shares, and if you worked for 4 years, you would ultimately vest in 100% of your shares.
Options usually have an expiration date of 10 years, so they must be exercised within that 10-year time frame or they expire. Also, options typically expire within 3 months of you leaving employment, so you must consider and likely act quickly to exercise shares that have been vested. However, if shares are not vested when you leave employment, they are generally worthless and you will be unable to exercise them. Vesting may also be accelerated in certain situations, such as the company being sold.
Below is an example of a typical stock option life cycle:
You begin work with ABC Tech in January of 2016 and are granted 100 shares of ABC Tech Common Stock with an exercise price of $10 per share and a 4-year vesting schedule with a 1-year cliff. If you leave ABC Tech in November of 2016, none of your shares will have vested so you won’t have any rights to the ABC Tech stock options you were granted. Instead, let’s assume you work with ABC Tech until July of 2021 and then leave employment for XYZ Tech. In July 2021, your ABC Tech Common Stock is worth $50 per share and since you’re leaving the company, you must exercise your right to purchase the shares within 3 months. Since the stock is now worth $50 per share, you exercise your right and purchase the 100 shares that are now fully vested, at price of $10 per share for a total price of $1,000. Your 100 shares are now worth $5,000 netting you a gain of $4,000. Depending on the type of option (ISO v. NSO), you will owe tax on the $4,000 gain.
Now, let’s assume you hold on to ABC Tech Common Stock for an additional two years at which point you decide to sell your stock at the market price of $80 per share. Since you held the stock for more than one year after exercising, you will receive long-term capital gains treatment on the gain between the $50 price when you exercised the stock and the $80 price when you sold the stock ($30*100). However, if you sold the shares less than one year after you exercised them, you would pay short-term capital gains tax (same as ordinary income tax rate). The tax implications of stock options vary depending on the type of option and your individual tax bracket, so be sure to consult with an accountant or tax attorney.
Stock options are a great way to incentivize employees and align their interests with the employer. As outlined above, there are a number of important factors to consider when issuing and receiving stock options such as type, vesting schedule, and acceleration provisions.
If you’d like to learn more about granting employee equity and planning the right stock structure for your company, please feel free to contact us today.