By now, most people have heard of or know a person who received stock options as part of their compensation and made a decent profit. But what are stock options?
Some companies offer employee stock options in exchange for a lower-than-expected salary. The expectation is that the company does well in a few years, and you’ll be able to exercise and sell those options as a financial reward.
However, you must understand how they work, or you may end up with a large tax bill or no options to exercise at all. Keep reading this stock options guide to learn what they are, how you receive them and your exercise options.
What Are Stock Options?
So you got a new job offer, and a part of their package includes a substantial non-cash payout. Congratulations!
Theoretically, if all goes well, then you can work your way up the corporate ladder, increase the value of your company and its stock and end up with a windfall when you decide to sell.
If equity compensation is new, then it’s likely you went online to search for stock options tips and came up with a list of day trading results. The options that people day trade and the ones granted to employees are essentially the same.
Options are contracts that give you, the employee, the right to purchase a predetermined number of shares in the company stock at a specific price. In order to take advantage of the options, you must opt to exercise them before the expiration date. Generally, this is ten years from the grant date, but it can change if you decide to leave the company earlier.
Additionally, the number of options granted to you by your company will consider several factors like your role, seniority, skillset and the vesting schedule.
The Vesting Schedule
When you get your new job offer and hear about the stock options for 25,000 shares you’ll receive, it can make your heart jump with excitement.
However, you must read the terms and outline to maximize your stock options. In most contracts, there will be a grant date which is when your options will begin to vest. That’s the day it’s available to you to buy or exercise.
Many companies will incorporate a vesting schedule, which is the period of time in which you’ll gradually receive your options. For example, assume you have a five-year vesting period with a one-year cliff.
That means after one year, you’ll receive a portion of your stock options and receive the rest over the following four years. Some companies may provide a large portion after the first year and gradually decrease until the contract is fulfilled. Others may provide an even amount every month after the cliff.
In this example, you won’t receive any options until the second year where you’ll receive the outlined amount of shares because of the one-year cliff. Afterward, the remaining options will vest according to the schedule in the contract for the remainder of the vesting period.
Once the stock options are vested, they’re yours but won’t hold any value until you decide to exercise them.
Exercising Stock Options
You pay a predetermined price or strike price when you exercise your options regardless of market value. Whether you own 5,000 stock options after your first year or all 25,000, you have two options.
You can hold onto them until the expiration date in hopes that the company’s stock will go up or exercise the options to become a shareholder and sell them.
Assume the vesting period is over, and you have all 25,000 stock options that you want to exercise and sell at the strike price of $1. This means you would have to come up with the entire $25,000 to exercise all the options.
However, you can take advantage of an exchange-and-sell-to-cover transaction. If offered, the brokerage firm will front the costs to exercise the options and sell the stock.
They then use the money from the sale to cover the costs. This includes the $25,000 plus commissions and fees. You would still be responsible for handling the tax implications from the exercise and sale.
The Best Time to Exercise Stock Options
The best time to exercise your stock options depends on several considerations. The first is if you’ll wait until your company decides to go public or not. By waiting, you run the risk of the company not going public and your options becoming diluted or even worthless.
Once your company’s stock is publicly traded, you’ll want to wait until the stock price is above and beyond your strike price. In this case, one dollar. If the market price is at $0.50 and your strike price is at $1, you end up losing money and with buyer’s remorse if the stock never exceeds the strike price.
The last consideration is one that many people struggle with, whether it’s stocks, real estate or any other investment or purchase. The key driver behind people wanting stock options is the profit potential.
So if the market value on your company’s publicly traded stock is at $5 and you have the option to purchase it for $1, would you sell or wait until it reaches a higher price point?
You could take on the risk, exercise your options, sell a portion of your shares, and hold the rest. However, that would mean you’re putting real money into purchasing shares.
Whereas, if you wait for a higher price to exercise, you have all your cash still in hand and can turn a quick profit without putting thousands of dollars on the line for an uncertain amount of time.
The best way to determine the right time and method of exercising your stock options is to speak with a financial advisor and a licensed CPA to cover your tax strategy and implications.
Getting the Most Out of Your Stock Options
In a world of readily available trading software for the average investor and Bitcoin, stock options are just one of many instruments that have become a household term in recent years.
But what are stock options? They’re much more complex than your regular paycheck, so it’s crucial to understand what they are and how they fit into your portfolio.
Regardless of the company, stock options are a speculative investment. It’s best to work with a fiduciary financial advisor to determine the best strategy for you.
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