Employee Stock Options: How They Work and What to Expect
Many companies offer employee stock options as part of their compensation packages, giving you an opportunity to benefit if the company’s stock price increases over time.
When an organization offers you stock options in the company, they’re not giving you the stock outright. Instead, they’re giving you the option to buy shares of the stock at a pre-determined price at some point in the future.
Being granted a chance to buy shares of stock and purchasing the stock occur on two separate occasions, usually with several years in between the two. These two points in time are known as the grant date and the exercise date, and the difference between them matters.
Grant vs. Exercise: How Employee Stock Option Plans Work
Before we dive into specifics, let’s review some important terms you will come across when discussing employee stock options:
- Grant Date – The date when the stock option (i.e., the right to buy the stock at a pre-determined price) is awarded to you.
- Vesting Schedule – The requirements to be eligible to exercise your stock options, usually met by waiting for a specified period.
- Strike Price – This is the price at which you can purchase the stock per 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 upon exercising the option. A positive spread indicates that your investment is in positive territory (i.e., the market value is higher than what you paid for it).
- Exercise – This refers to the decision to purchase the stock at the pre-determined strike price per the terms of your grant. Note that you are not required to exercise your stock options (e.g., you wouldn’t exercise the option if the market value was lower than the strike price).
- Expiration Date – The date upon which you are no longer able to exercise the option to purchase the stock.
Here’s a simplified example of how grant vs. exercise works:
Let’s say your company grants you the option to buy 1,000 shares of stock at $15 per share, for a total of $15,000. The shares will vest over five years at 20 percent per year (or 200 shares per year).
This means that after the first year, you will be eligible to exercise, or purchase, 200 shares of the total 1,000 shares of stock, with an additional 200 shares vesting each year thereafter.
Now, let’s say that upon exercise, your stock’s market value is $20 per share. This results in a spread of $5 per share, or $5,000 in total. But because your grant specified a $15 strike price, that is the price you’ll pay for your stock—not the current value of $20 per share.
What to Expect Upon Exercise
To be clear, you do not have to exercise your stock options upon vesting. Most employee stock options come with an expiration date, allowing you to exercise your options at any point before the expiration date as long as the shares have vested.
Using the above example, let’s say your grant included a 10-year expiration date. If you received your grant on 1/1/2020, then you have until 1/1/2030 to exercise your stock options. Given a five-year vesting schedule, you will fully vest by 1/1/2025.
If you decide to exercise your stock options, you have a couple of different options to pay for them.
If you want to purchase them outright, you will need to pay $15,000 to the brokerage firm managing the stock options. Employees who plan on electing this option usually put away money each year to cover the cost, as they already know how much their options will cost to exercise.
Another option is to 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 to receive your stock (though you will end up with fewer shares).
Some employees choose to exercise their stock options and sell all of their shares immediately to pocket their gains. This can be a way to recognize the profit on your option grant and receive cash, but you will no longer hold the stock, potentially forgoing 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.
Read more from our blog: