Stock Option Basics

What exactly is a stock option?

A stock option is the right, but not the obligation, to buy stock at a specific price (called the strike price).

Why do companies offer stock options?

Stock options provide you with the incentive to own part of the company, and to ultimately participate in the company's success. They also help startups and small businesses attract and retain talent when they don't have the cash to compete with more established companies.

How are they issued?

Let's go through a typical example to illustrate how an equity compensation package may be presented to you. Don't worry if you haven’t seen all of the terms, we’ll explain them throughout.

You join a small startup on January 15th, 2013, and as part of your compensation package you’re granted 1,000 stock options at a $1.00 strike price with a 10 year expiration.

In plain english, this means you were granted the option to buy 1,000 shares at $1.00 per share, no matter what the stock price is in the future. You have 10 years to act on these options, after which they expire and are worth nothing.

When these options are first granted on January 15th, 2013, you can't yet buy them. That's because most stock option grants have a holding period, called a vesting schedule, which indicates when your options can be exercised. This prevents you from buying all of the stock at once, and instead spreads the buying over time. It's great for companies to incentivize employees to stay long-term, and prevents new hires from joining, buying, and leaving without putting in any effort.

Vesting is most often a function of time, but can also be based on events or milestones (e.g. company performance). Let's continue the example with a time-based vesting schedule:

You have a 4 year vesting schedule where 25% will vest on the one year anniversary of the grant date, with monthly vesting thereafter.

The one-year anniversary is referred to as the cliff, which is the first vesting milestone. If you leave the company before the one year anniversary, you would forfeit the entire grant.

After the cliff the vesting iterates monthly, so think about the entire grant term as 48 months. On the cliff date, you'll vest 25% of the grant, or 12/48ths. Each successive month you'll vest an additional 1/48th, which will look something like this:

Vesting Progress

After 48 months you'll have vested the entire stock option grant. If you leave at any point, you'd have the option to exercise only what you've vested and forfeit the remainder of the unvested options. For example, if you left after 30 months you would have vested and can exercise 30/48ths, or 625 of the 1,000 stock options.

Should I exercise my vested options?

There's no straightforward answer to this question but to tell you to consult an accountant. Your decision will come down to personal circumstances and a bet on the company's future. Here are common reasons that option holders exercise:

You’re leaving the company. Depending on the type of stock options you receive (explained further below), you may have to exercise your options within 90 days of leaving the company. If you don’t act in that short window, you’ll forfeit all unexercised options.

A company liquidity event. Most private companies are illiquid, meaning that if you exercise stock you still won’t be able to sell your shares. That adds risk to your decision, as you’re placing a bet on the future of the company. However, there are two primary events where a company becomes liquid and you can sell your shares: an acquisition and an IPO.

The current price-per-share is still low. This also depends on the type of options you have, as there are varying tax implications when you exercise. But if you’re set on buying the stock, and the current price is at or near your strike price, your tax burden will be much smaller if you exercise early.

The company is growing rapidly. Exercising almost never guarantees profit, but if your company’s valuation is quickly moving up-and-to-the-right (and you can afford the tax burden) some option holders will choose to exercise in anticipation of future liquidity.

The company allows you to sell shares on a secondary market. As the company grows to larger levels, the board may vote to allow shareholders to get liquidity by selling shares on a secondary market like SharesPost or SecondMarket.

What are the different stock option types?

Not all stock options are created equal, and the differences are rooted in tax law. For most companies, the two stock option types typically used are Incentive stock options (ISO) and Nonqualified stock options (NSO).

ISOs are reserved specifically for employees, and have tax advantages over NSOs depending on how long you hold onto them. If you fully take advantage of ISO tax savings, you can drop your tax rate to long-term capital gains (currently 15% for most people) instead of paying your ordinary income tax bracket (currently up to 39.6%). More on taxes below.

NSOs can be issued to both employees and non-employees. They’re “nonqualified” because they don’t qualify for the tax advantages reserved for ISOs, and you’ll be taxed at your ordinary income tax bracket.

For more details, take a look at What’s the difference between an ISO and an NSO? from Yokum at Startup Company Lawyer, which further explains the difference between these differing stock options.

How do taxes impact my options?

Taxes play a critical role in the decision to exercise, and the implications vary based on the type of stock that was issued to you.

If you have ISOs, we mentioned there are tax savings at play, which comes in the form of an IRS calculation called the Alternative Minimum Tax (AMT). Ignoring edge cases, the IRS uses the AMT to calculate tax on the difference between the fair market value and the strike price.

Let's say you exercise 10,000 options at a strike price of $1.00, when the fair market value is $5.00. The AMT calculation cares about the $4.00 difference between the exercise price and fair market value, which in this example is $40,000 ($4.00 spread x 10,000 shares). The IRS will tax that spread using the AMT calculation, which is will be much less than regular income tax.

NSOs are treated differently. If options are granted below the fair market value, taxes may apply when the options vest even if you decide not to exercise. And when you do exercise, the spread is taxed as regular income at higher rates.

Evaluating your stock option package

Now that you’re well versed on stock options, you’ll have a better idea of how to evaluate them. One additional question you'll want to ask is how many shares are outstanding; with this number you can calculate the percentage of the company that your option represent. That percentage will change over time, but if the company is doing well you'll just have a smaller slice of a larger pie.

A few final thoughts

Stock option types vary by business structure; for example an LLC will often have a different structure of issuing equity compensation compared with a C Corporation. We covered the more common C Corp structure in this post, but will soon do a follow-up on LLC's to discuss the differences.

This information is meant to serve as a basic guide to common stock option scenarios. Please consult a lawyer or accountant before making serious decisions, as no information in this article is to be interpreted as legal or financial advice.