Simple Examples of Stock Options

What are Stock Options?

Stock options are a benefit companies offer employees, giving them the right to purchase company stock at a specific price, known as the exercise price, within a set period. The key difference from buying stock on the open market is that options are not immediately exercisable. You have to wait for them to "vest," meaning you earn the right to exercise them after a certain time or performance milestone.

Example 1: The Offer

Let’s start with a straightforward example: you are hired at a startup and offered 10,000 stock options at an exercise price of $5 per share. This means that if you choose to exercise your options, you can buy each share at $5, no matter the current market price. Typically, companies set a vesting schedule, meaning you might not have access to all 10,000 options right away. Let’s say you vest 25% of your stock options each year over four years. After your first year, 2,500 of your options are available to exercise.

Example 2: Exercising Stock Options

Fast forward a year, and the company's stock price has risen to $10 per share. Congratulations! You now have 2,500 vested stock options at $5 per share, but on the market, they’re selling for $10. By exercising your stock options, you could buy 2,500 shares at $5 each, totaling $12,500. If you immediately sold them on the market for $10 each, you’d make $25,000, turning a $12,500 profit before taxes and fees.

Example 3: Waiting to Sell

In another scenario, you might decide not to sell your shares immediately after exercising your options. Maybe you believe the company will grow even more, and the stock price will rise. This is where the risk comes in. Stock prices can fluctuate, and if the price drops below your $5 exercise price, you could lose the potential profit. However, if the stock price rises to $20, you stand to make an even bigger profit.

Example 4: Stock Option Expiration

What if you leave the company? In most cases, you’ll have 90 days to exercise your vested options, or they expire. If you don’t act within this period, you lose the right to buy the shares. On the other hand, any unvested options are forfeited upon your departure.

Stock Options vs. RSUs: A Comparison

It’s crucial to differentiate between stock options and restricted stock units (RSUs), as they are often confused. RSUs are essentially company shares given outright after they vest. Unlike stock options, there’s no purchasing involved. Once they vest, they are yours to keep or sell, and you owe taxes on their value at the time of vesting. In contrast, stock options offer more control and potentially higher rewards if the stock price appreciates significantly, but they also carry more risk because the price could drop.

Example 5: An RSU Scenario

Let’s say you receive 5,000 RSUs from your company, and the stock is trading at $10 per share when they vest. You now own 5,000 shares worth $50,000, and that is taxable income. With RSUs, there’s no exercise price or decision about when to buy. The shares are yours once they vest, though you might want to wait for an optimal time to sell.

The Upside and Downside of Stock Options

The beauty of stock options is that they allow employees to share in the company’s success. If the company does well and the stock price soars, employees can make significant profits. However, stock options can also be worthless if the stock price does not exceed the exercise price.

Let’s take a look at the pros and cons of stock options:

Pros:

• High upside potential: If the company grows, your stock options could be worth much more than you paid for them.
• Incentivizing employees: Stock options motivate employees to contribute to the company’s success, aligning their goals with those of the business.
• Tax advantages: Depending on how long you hold the stock after exercising options, you could pay lower capital gains tax rather than regular income tax.

Cons:

• Risk of loss: If the stock price does not rise above the exercise price, your options may be worthless.
• Complexity: Stock options come with rules, deadlines, and tax implications, which can be confusing to navigate.
• Limited window to exercise: If you leave the company, you often have a short time window to exercise your options.

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

There are two main types of stock options: Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs).

• NSOs: These options are available to both employees and external partners, like contractors. They are subject to ordinary income tax on the difference between the exercise price and the market price at the time of exercise.

• ISOs: Reserved for employees, ISOs are treated more favorably for tax purposes. If you hold onto your shares for at least one year after exercising and two years after receiving the option, you may qualify for long-term capital gains tax rates, which are lower than regular income tax.

Example 6: The Tax Impact of ISOs

Assume you have 1,000 ISOs with an exercise price of $10, and you exercise them when the stock is trading at $50. If you sell them after holding for one year, you’ll pay capital gains tax on the $40 difference per share. If you sell earlier, you’ll pay ordinary income tax, which could be significantly higher.

Should You Exercise Stock Options?

There’s no universal answer to whether or when you should exercise stock options. It depends on factors like your personal financial situation, the company’s growth prospects, and how long you plan to stay with the company.

Example 7: The Wait-and-See Approach

Let’s say your company’s stock is currently trading at $15, but your exercise price is $10. You might decide to wait and see if the stock price rises higher, giving you a larger potential profit. However, waiting too long could lead to missing your exercise window if you leave the company, or worse, the stock price could drop below your exercise price, making your options worthless.

Key Takeaways

Stock options can be a valuable part of your compensation package, but understanding how they work is crucial to making the most of them. With examples like buying shares at a fixed price, navigating vesting schedules, and comparing tax implications, stock options become less of a mystery and more of an exciting opportunity. However, they come with risks, and timing is key.

Whether you are a startup employee or an executive at a large corporation, stock options can be your ticket to wealth – but only if you understand the game.