Equity 101 Part 1: Startup employee stock options

An option is created that specifies that the owner of the option may 'exercise' the 'right' to purchase a company's stock at a certain price the 'grant' price by a certain expiration date in the future. Usually the price of the option the 'grant' price is set to the market price of the stock at the time the option was sold.

If the underlying stock increases in value, the option becomes more valuable. If the underlying stock decreases below the 'grant' price or stays the same in value as the 'grant' price, then the option becomes worthless.

They provide employees the right, but not the obligation, to purchase shares of their employer's stock at a certain price for a certain period of time. Options are usually granted at the current market price of the stock and last for up to 10 years. To encourage employees to stick around and help the company grow, options typically carry a four to five year vesting period, but each company sets its own parameters.

Advantages Disadvantages Allows a company to share ownership with the employees. Used to align the interests of the employees with those of the company. In a down market, because they quickly become valueless Dilution of ownership Overstatement of operating income Nonqualified Stock Options Grants the option to buy stock at a fixed price for a fixed exercise period; gains from grant to exercise taxed at income-tax rates Advantages Disadvantages Aligns executive and shareholder interests.

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Company receives tax deduction. No charge to earnings. Dilutes EPS Executive investment is required May incent short-term stock-price manipulation Restricted Stock Outright grant of shares to executives with restrictions to sale, transfer, or pledging; shares forfeited if executive terminates employment; value of shares as restrictions lapse taxed as ordinary income Advantages Disadvantages Aligns executive and shareholder interests. However, the paper gains on shares acquired from ISOs and held beyond the calendar year of exercise can subject you to the alternative minimum tax AMT.

This can be problematic if you are hit with the AMT on theoretical gains but the company's stock price then plummets, leaving you with a big tax bill on income that has evaporated. Stock option taxation is an important subject for all optionholders to understand. Now that you know the basic workings of stock options, you should learn the details of their tax treatment. For international employees, the Global Tax Guide has information on the tax treatment of stock options and other types of equity compensation in many different countries.

Matt Simon is one of the writers and editors at myStockOptions. Need a financial, tax, or legal advisor? Search AdvisorFind from myStockOptions. Tax errors can be costly! Don't draw unwanted attention from the IRS. Our Tax Center explains and illustrates the tax rules for sales of company stock, W-2s, withholding, estimated taxes, AMT, and more.

Podcast included: In addition to this article, this website also has a podcast on stock option basics. See also our brief video on core aspects of stock options. After reading this article, test your knowledge with a fun, interactive quiz on stock options If you are reading this article, your company has probably granted you stock options. Stock options give you a potential share in the growth of your company's value. An option grant can be set up so that it vests either all at once cliff vesting or in a series of parts over time graded vesting.

Stock options become valuable only if the stock price rises, thus creating a discount between the market price and your lower exercise price. ISO taxation is complex. You must understand how the alternative minimum tax can affect you. Print this article:. Share this article:.

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We've updated our Privacy Policy, and this site uses cookies. Stock Options Help Create an Ownership Culture Companies who issue stock options to their employees are, in effect, issuing the right to own a portion of the company. There are two types of stock options, classified by their tax status. What you may gain by waiting. What are your expectations for the stock price appreciation and the market in general?

Employee stock options

How much time remains until the stock option expires? Do you need to act quickly, or do you have more time? The rules of your plan. You don't have to exercise all your stock options at one time, however, minimums and fees may apply. Your plan rules will have the details. Your current and future financial needs.

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Is this an opportunity to improve current cash flow or an investment for the future? Your current and potential future tax situation. Exercising stock options has tax consequences.