Explaining the Stock Options Process in 3 Easy Steps

Stock options are a great benefit that companies can offer employees, as it gives employees the option to purchase company stock at a low price and earn additional income. Familiarizing yourself with the process can help you plan ahead and make the most of this extra benefit.

What Are Stock Options?

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A stock option is a contract that gives someone the option, although not the obligation, to buy or sell a stock at a specific price within a certain timeframe. Companies sometimes award stock options as a form of compensation, in which employees are paying for stock options at a price lower than what they would buy it on the open market.

How Employee Stock Options Work

Stock options are a form of compensation for investors, employees, and even consultants. These individuals are given the right to purchase a specific number of shares of employee stock at a set price, known as a grant price.

Understanding the Grant Date and Vesting Schedule

When you are given stock options, there will be a grant date on the contract that indicates when the stock will begin to vest. When a stock is vested, you have the right to buy or exercise it. You generally will not receive all of your stock options right when you are hired by a company, though. There is usually a four-year vesting period, during which 25% of the stock options will vest each year, although there may be other stipulations.

When To Exercise Stock Options

You are given a specific time in which you have the right to exercise your stock options. However, you wait until your company goes public before buying stock. If your company doesn’t go public, the shares you purchased may be worth even less than you paid for them.

When the company does go public, you should wait to exercise your options until after the market price is above the exercise price. For example, if you have the option to buy a stock at $2 per share, it doesn’t make sense to buy shares of the stock until it is over that price.

Paying Taxes on Your Stock

You are required to pay taxes when you buy or sell stock options, although the amount you will pay depends on the type of stock options you have. Non-qualified stock options (NQSOs) are the most common type of stock option, and they don’t receive special tax treatment.

When you are ready to sell your shares of company stock, you will be required to pay taxes based on the length of time that you held them. In the event that you exercise your right to buy and sell within one year, you’ll need to report the income as a short-term capital gain. If you sell after one year, it is considered a long-term capital gain. With the other type of stock option, incentive stock options, you don’t pay taxes when you buy the options, only when you sell your shares.

While the benefit of stock options is not as straightforward as a paycheck, it does have the potential for a large additional payday for employees. Understanding the type of options the company is offering and the length of the vesting period can help you plan ahead to make the most of this benefit.