The graphic below illustrates the concept of a typical graded vesting schedule. While vesting periods for stock options are usually time-based , they can also be based on the achievement of specified goals, whether in corporate performance or employee performance see the FAQ on performance-based stock options.
Stock options always have a limited term during which they can be exercised. The most common term is 10 years from the date of grant. Of course, after the vesting period has elapsed, the actual amount of time to exercise the options will be shorter e. If the options are not exercised before the expiration of the grant term, they are irrevocably forfeited. Employees who leave the company before the vesting date usually forfeit their options. With vested options , departing employees typically have a strictly enforced timeframe often 60 or 90 days in which to exercise—they are almost never allowed the remainder of the original option term.
Since the exercise price is nearly always the company's stock price on the grant date, stock options become valuable only if the stock price rises, thus creating a discount between the market price and your lower exercise price.
What You Need to Know About Stock Options
However, any value in the stock options is entirely theoretical until you exercise them—i. After you have acquired the shares through this purchase, you own them outright, just as you would own shares bought on the open market. Depending on the rules of your company's stock plan, options can be exercised in various ways. If you have the cash to do so, you can simply make a straightforward cash payment , or you can pay through a salary deduction.
Alternatively, in a cashless exercise , shares are sold immediately at exercise to cover the exercise cost and the taxes. If your company's stock price rises, the discount between the stock price and the exercise price can make stock options very valuable. That potential for personal financial gain, which is directly aligned with the company's stock-price performance, is intended to motivate you to work hard to improve corporate value.
In other words, what's good for your company is good for you. However, by the same token, stock options can lose value too. If the stock price decreases after the grant date, the exercise price will be higher than the market price of the stock, making it pointless to exercise the options—you could buy the same shares for less on the open market. Options with an exercise price that is greater than the stock price are called underwater stock options.
Beware: Stock Options Will Expire If Not Exercised
Companies can grant two kinds of stock options: nonqualified stock options NQSOs , the most common type, and incentive stock options ISOs , which offer some tax benefits but also raise the risk of the alternative minimum tax AMT. Thus the word nonqualified applies to the tax treatment not to eligibility or any other consideration.
NQSOs are the most common form of stock option and may be granted to employees, officers, directors, contractors, and consultants. You pay taxes when you exercise NQSOs. When you sell the shares, whether immediately or after a holding period, your proceeds are taxed under the rules for capital gains and losses. For a detailed explanation of the tax rules, see the related sections of the Tax Center on this website.
However, to qualify they must meet rigid criteria under the tax code. ISOs can be granted only to employees , not to consultants or contractors. Also, for an employee to retain the special ISO tax benefits after leaving the company, the ISOs must be exercised within three months after the date of employment termination.
When Should You Exercise Your Stock Options?
After you exercise ISOs, if you hold the acquired shares for more than two years from the date of grant and more than one year from the date of exercise, you incur favorable long-term capital gains tax rather than ordinary income tax on all appreciation over the exercise price. However, the paper gains on shares acquired from ISOs and held beyond the calendar year of exercise can subject you to the alternative minimum tax AMT.
This can be problematic if you are hit with the AMT on theoretical gains but the company's stock price then plummets, leaving you with a big tax bill on income that has evaporated. Stock option taxation is an important subject for all optionholders to understand. I also pay close attention to the boilerplate traps that trip up many agreements.
Stock Options The Essentials -
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Jump to Section. Need help with a legal contract? How Exercising Employee Stock Options Works Before considering whether it makes sense to exercise stock options, it is important to understand how they work. Understanding Basic Stock Options Terms Exercise Price — The exercise price, also known as the grant price or strike price, is a price set by the issuer that reflects the fair market value of the stock.
This is also the price the employee will be able to purchase, or exercise , their stock options in the future. Grant Date — The grant date is the day the issuer of the stock options grants them to the employee. This date is typically listed on the stock options agreement the employee signs as part of their employment contract. Example for Grant Date: If an employee signs an options grant on January 1, , the grant date is most likely January 1, since it will be listed on the agreement and become legally binding upon signature.
Number of Shares — The number of shares is the number of stock option shares the issuer is granting to the employee. These are the shares the employee may have the opportunity to buy in the future. Exercise Method — The exercise method is the way the employee will be required to pay for the shares in the future, should the employee choose to exercise them. Cash and stock swaps are two forms of exercise methods. Vesting Schedule — The vesting schedule outlines the timeframe the employee will need to stay with the company in order to earn the right to buy the options.
This essentially means: All stock will be vested after four years of service at the employer. The employee needs to work a minimum of one year for any stock to vest. After one year of service, the remaining stock will vest incrementally on a monthly or quarterly basis. Expiration Date — The expiration date is the day which the employee will no longer have the ability to buy the option shares.
This is typically years after the grant date. Here is an article on vesting stock. Meet some lawyers on our platform. Carlos C. Eric M. Ramsey T. Donya G. Get Free Bids to Compare Leverage our network of lawyers, request free bids, and find the right lawyer for the job. Get Bids Now. Explore Our Network of Lawyers We recruit and onboard great lawyers so you can find and hire them easily. Browse Lawyers Now. Meet some of our Lawyers Jennifer S. View Profile Get Free Proposal.