Tis the season of equity awards grants – truly an exciting time! What better time to revisit stock options and restricted stock units – how do both of these plans work and what are some strategies for each? Today’s blog will be the first in a four part series on this topic. Today, I’ll focus on the basics of stock options.
How does a stock option work?
Whether stock options are new to you or not, a quick refresher on how they work can never hurt. Typically, a stock option is awarded in unvested shares with a staggered vesting schedule. For instance, let’s say you received 10,000 options at DuPont in February 2018. They would vest on a schedule of 1/3 a year from 2019 to 2021. Unlike restricted stock units (RSU), when they vest there is no taxable event. When stock options vest, there is generally an expiration date for when you must exercise them. Otherwise, you lose the option. When you are awarded a stock option, basically you are just given the option to purchase your company’s stock in the future (before expiration) at the price of the stock the day you received them. When you exercise the option, it’s generally a “cashless” transaction. Let’s use the above DuPont example. You have all 10,000 of your shares vested. Now, let’s assume when awarded your company stock was worth $10/share. Basically, every dollar the stock increases over $10 is worth $10,000 to you before-tax. Simple math, if the stock today is $25/share and you exercise, you don’t have to come out of pocket to purchase the $10 option (so long as you are selling immediately). Rather, you just get the $15/share growth (10,000 shares = $150,000 value to you). With stock options, you are taxed upon exercising the option. Since it’s an immediate purchase and sale, you are taxed based upon ordinary income tax rates. Some companies will allow you to actually purchase the option. If you are able, you could possibly avoid paying taxes at ordinary income tax rates. If you own the option for more than a year, then exercised, you would instead pay at a long-term capital gains rate. There are two concerns here:
- Your company has to allow this to happen.
- You would need the liquidity to afford the purchase. (In my example above, you would need $100,000 liquid just to cover the 10,000 shares.)
Although stock options can be lucrative, they also run the risk of being worthless. Remember, the option is only worth money for every dollar it increases over the issue price. For example, you received stock at $10/share. Over the lifespan of your option, it never goes above that $10 again. Your option would expire in what they call “out of the money.” In other words, why would you purchase a stock for $10, if the fair market value is $5?
Why do companies give stock options?
Generally, stock options are awarded to executives in publicly traded companies. They are a great way to both compensate and incentivize these executive level employees. Stock options allow employees to partake in the profitability of the company. Most importantly, they are a “golden handcuff” for the employer. Most often it’s hard for someone to walk away from many years of stock options, especially if there is substantial unvested value.
How do companies determine the value of the stock option?
Theoretically, when a company gives an employee a stock option it’s worthless on day one. The option price to exercise is the same as the stock price. So, how do they assign a value to these options? Most companies revert back to the Black-Scholes Formula (defined here by Investopedia). This is a way to give a value based on expected price, growth, and time horizon of the underlining option. It is far from an exact science. However, it offers a good way to assign value onto an otherwise seemingly worthless option.
Final thoughts on options.
I have personally seen stock options change people’s lives. Despite being riskier than their restricted stock unit counterparts, their upside is much greater. Thus, they have the ability to have a life altering effect. My advice is to work your hardest and try to get into the stock option pool as early as you can. The long-term effect could be instrumental to your financial success.