26 Nov Concentrated Stock Position Series, Part 1: Employee Stock Option Plans (ESO Plans)
Written by Marcus Dusenbury, Financial Advisor
So you just got stock options from your employer . . . now what?
Employee stock option plans (ESO plans) have been around for a few decades now. They are an employee benefit plan through which companies offer employees “options” to buy shares of the employer stock at a set price. ESO plans are usually associated with publicly traded companies, but they can also be established by private companies whose goal may be to go public in the future. ESO plans gained prominence and popularity in the late 1990s and early 2000s during the Dot-Com Boom. Indeed, they are most often associated with growth-oriented industries like technology and biotech, although they can be found in other sectors as well.
So, what do you do if you receive employee options as part of your benefit package? Let’s start by covering the basics of how they work. Each option gives the owner the right to buy one share of the company’s stock at a preset price (sometimes referred to as the ‘strike price’). When the option is given, it typically has little to no value because the stock price is about the same price as the option (we’ll go through an example in moment). As the stock price increases, however, the option price—at which you can buy stock—stays the same (at the predetermined price), which makes the option increasingly more valuable for the owner.
The preset option price, at which you can exercise the option and receive one share of common stock, is known as the option’s “strike price.” The strike price is determined by the issuer (your employer) at the time the options are issued. Different companies use different formulas to determine pricing for their employee options, but it is usually the fair market value of the stock on the date of issuance.
Here’s an example. Let’s say you join a new employer and they give you 1,000 options to buy the employers stock, with a strike price equal to the closing stock price on that “date of issuance,” which we’ll say was $100. Now let’s fast forward one year and say the current market value of the stock is $200 per share. You now have the right to “exercise” your option and purchase 1,000 shares of stock at the “strike price” of $100. You can then turn around and sell those shares in the open market for $200—a profit of $100 per share, or $100,000 ($100 X 1,000 shares).
A vesting schedule is simply the timeframe from the date you receive employee options to the date you must exercise. Employee options have a shelf life, or expiration date, which is determined by the issuer. Historically, the most common shelf life for employee options is 10 years, but they can sometimes be shorter. You can exercise options (exchange them for stock) prior to that expiration date, but only the options that have “vested.” A common vesting schedule for stock options is 20% each year for the first five years, with a 10-year expiration date on all of them. Some companies use each employee’s anniversary dates, while others have a set date for all employee vesting.
Using the above common vesting schedule, as an example would look like this:
1,000 options at a strike price of $100
- 200 options become vested (available to exercise) after 1 year
- 200 more options become vested after the second year
- 200 more options become vested after the third year
- 200 more options become vested after the fourth year
- 200 more options become vested after the fifth year
- All of the options that haven’t been exercised by end of the 10th year expire and become worthless.
Option Types: NQ versus ISO
There are two different types of options that an employer can offer in their plan. The first type is the “Non-Qualified” Stock Option (often referred to as “NQs”) and the second type is the “Incentive” Stock Option (or “ISOs”).
The type of option you receive typically depends on how high up in the company you are. Generally speaking, ISOs are more advantageous from a tax standpoint, and therefore are given to higher-value, management-level employees. NQs are normally part of more standard benefit packages.
Tax Ramifications and Strategies
The main difference between NQs and ISOs is in the way they are taxed.
- Non-Qualified Stock Options (NQs) are—at the time they are exercised—taxed on their “gain,” which is the difference between the option’s strike price and the stock’s fair market value (FMV)—the price of the stock on the stock market—at that time. The gain counts as ordinary taxable income (not capital gain) to the option owner. If the stock price stays below the option strike price, however, then the options have no value (and you would not exercise them), so they expire worthless.
- Incentive Stock Options (ISOs) are taxed as ordinary income, just like NQs, if you exercise them and then sell the stock within a year thereafter. However, if you exercise ISOs and then hold onto the stock for more than a year (even just one day more), your gain gets treated as long-term capital gain, which could be taxed at much lower rates than ordinary income for most people.
If you are given incentive stock options (ISOs), and you are optimistic about your company’s future prospects, it generally behooves you (from a tax standpoint) to exercise the options (paying the strike price and receiving stock shares), hold onto the stock for over a year, and then sell the shares for a long-term capital gain. This almost always results in significantly less taxes, especially if you are in a high tax bracket. However, it also entails the risk of holding the stock for a year, during which its price might drop. Be careful to not let tax planning keep you from making good investment decisions; if you are concerned about the company’s immediate prospects, you might want to sell at least a portion of your shares as soon as you exercise the ISOs. Paying higher taxes on some gain is better than paying lower taxes on little or no gain.
If you are given nonqualified stock options (NQs), it generally makes sense to place a same-day-sale transaction, whereby you exercise (exchange into stock) the option and sell that stock the same day. Remember, NQs will be taxed as income whether you sell the resulting stock shares or hold them. To help spread the income tax burden, if possible, exercise NQs over a number of years (for instance 10% each year). Exercising all of them at once (such as on or near their expiration date, as many people do) may push you into higher tax brackets.
Develop a Plan for Your Options
Whatever you choose to do, always plan ahead. Make sure that you know the tax ramifications before you make any transactions, rather than finding out after the fact. That’s where good advice comes in very handy.
What makes ESO plans so hard to navigate, and the reason many participants procrastinate making decisions until just before their expiration date, is the sheer number of possible scenarios. ESO plans can be fairly simple to understand; however, managing them effectively can require fairly complex planning. Their numerous moving parts and variables make a single black-and-white “right” answer almost impossible to predict. Indeed, strategizing on your own can be financially chancy.
One of the best strategies, therefore, is to find someone with a good deal of experience managing employee options and have them help you develop and put in place a plan specifically for you. ESO plans can be a great financial benefit. With professional advice, you can make the most of your employee stock options and use them effectively to achieve greater financial prosperity.
About the author: Marcus Dusenbury is a founding shareholder and fiduciary advisor with Viridian Advisors. He has 20 years of experience working with corporate stock benefit plans including those for Intel, Expedia, Amgen, among many others. Viridian is an SEC Registered Investment Advisor (RIA) with clients across the United States. Viridian offers financial planning, asset management, employee benefits advice, as well as tax services through its sister company, Viridian Tax and Accounting.