Employee Stock Options: How They Work and What to Expect
Many companies include employee stock options in their compensation packages, providing a chance to profit from the company’s stock value growth.
When a company grants you stock options, it doesn’t mean you immediately receive the stock. Rather, it offers you the choice to purchase shares at a predetermined price in the future.
The grant date, when you receive the option to buy shares, and the exercise date, when you decide to purchase the stock, are distinct events usually spaced several years apart. Understanding the difference between these two points in time, the grant date and the exercise date is crucial.
Grant vs. exercise: how employee stock options work
Before we get into the details, let’s go over some essential terms related to employee stock options:
- Grant Date: The day you receive the stock option, giving you the right to buy the stock at a predetermined price.
- Vesting Schedule: The conditions you must meet to be eligible to exercise your stock options, often involving a waiting period.
- Strike Price: The price at which you can buy the stock according to the terms of your grant.
- Market Price: The current value of the stock.
- Spread or Bargain Element: The difference between the strike price and the market price when you exercise the option. A positive spread means your investment is in positive territory.
- Exercise: The decision to purchase the stock at the predetermined strike price, though it’s important to note that exercising is optional, especially if the market value is lower than the strike price.
- Expiration Date: The date after which you can no longer exercise the option to purchase the stock.
Now, let’s break down these terms with a straightforward example:
Imagine your company allows you to buy 1,000 shares at $15 per share, totaling $15,000. Over five years, the shares vest at 20 percent per year (or 200 shares per year).
After the first year, you can exercise (purchase) 200 shares, with an additional 200 vesting each subsequent year. If, upon exercise, the market value is $20 per share, you have a spread of $5 per share or $5,000 in total. However, you pay the $15 strike price as specified in your grant, not the current $20 per share value.
What to expect after
To clarify, you’re not required to exercise your stock options as soon as they vest. Typically, employee stock options have an expiration date, and you can exercise them at any point before that date, provided the shares have vested.
For example, if your grant has a 10-year expiration date and you received it on 1/1/2020, you have until 1/1/2030 to exercise your stock options. Assuming a five-year vesting schedule, full vesting would occur by 1/1/2025.
When it comes to paying for the exercise of your stock options, you have a couple of choices. If you prefer to buy them outright, you’ll need to pay $15,000 to the brokerage firm managing the stock options. Some employees who opt for this method set aside funds each year to cover the cost since they already know the exercise price.
Alternatively, you can exercise your stock and immediately sell enough shares to cover the purchase price. The brokerage firm handles this in a single transaction, so if the value of your stock options is higher than the strike price, you won’t have to pay anything out-of-pocket (though you’ll end up with fewer shares).
Certain employees choose to exercise their stock options and sell all their shares right away to realize profits. While this allows you to cash in on your option grant, keep in mind that you’ll no longer hold the stock, potentially missing out on future growth
Our financial planners and tax experts can help you explore alternatives for exercising your stock options and help you plan for your future. Reach out to our team to get started.
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