If you work in a booming industry, have a rare skill, or simply get lucky at the right company, you might land a job offering stock options.
Owning a piece of a company’s growth can provide an extra incentive on the job, and it has helped employees at all sorts of companies—including Microsoft, Amazon, Google, and Facebook—build substantial wealth. When considering or comparing a compensation package with stock option benefits, understand exactly how stock options work and what they might be worth.
What Is a Stock Option?
A stock option gives an employee the ability to buy shares of company stock at a certain price, within a certain period of time. The price is known as the grant price or strike price, and it’s typically based on a discounted version of the price of the stock at the time of hire. Purchasing the stock shares at the grant price is known as exercising your options.
Employees who exercise their options and sell their shares when the company’s stock is trading significantly higher than the grant price have the potential to make a lot of money. For example, say you have the option to buy 5,000 shares at $10 and sell the stock at $50, with a $50,000 investment you end up with $250,000.
How do employees come up with the cash to exercise the options and buy the stock? You can use savings, rollover proceeds from another stock sale, or borrow from a brokerage account and pay it back immediately. Because stock option plans typically vest over time, employees don't need to purchase the shares all at once. Under a typical vesting schedule, the employee may only own 25% of their options after year one, another 25% after year two, and so on, until 100% vested in year four or five.
Timing is important, however. If the stock price is trading lower than the grant price, the options are said to be underwater. Exercising options is useless if the employee can buy shares of the company stock for less on the open market.
Types of Stock Options
There are two types of stock options: qualified incentive stock options (ISOs) and nonqualified stock options (NSOs). Most employees get NSOs, which are priced at a discount and taxed at ordinary income tax rates. Qualified ISOs, usually reserved for top executives and key employees, are taxed at a lower capital gains rate, which tops out at 20% for gains on investments held for longer than a year.
A tax hit occurs once the options are exercised, so you pay either income tax or capital gains tax depending on whether your option is qualified, based on the grant price. Once you exercise the options, you can sell the shares after a short waiting period or hold onto the shares and wait for the stock to increase further before selling. Some investors hedge their bets by doing a bit of each.
Why Do Employers Offer Stock Options?
Once reserved only for the executive team, stock options became a popular form of compensation during the tech boom in the late 1990s. In fact, the National Center for Employee Ownership (NCEO) reports that there were 30% more workers with stock options in 2001 than in 2014. Back then, there were many tales of stock option success, and certain types of employees were looking for a sense of ownership in their workplace that went beyond the paycheck. Stock options offered a way to give everyone in the company an additional stake in the business’ growth.
By 2001, so many options were underwater that they lost some of their appeal among the corporate masses. But in the world of start-ups, enough people got very wealthy from stock options that they remain a great tool for attracting early-stage talent.
There are a variety of reasons employers want to offer stock options. Discounted company stock can increase a loyal employee’s compensation without hurting profits. Vesting programs can help build longer-term loyalty among employees. The sense of shared ownership can foster a strong corporate culture. Employees literally help to grow the company not just as staff, but as shareholders.
For employees, stock options can result in tremendous wealth, particularly if you join the company at an early or growing stage. On the flip side, those are the companies that are also likely to go under with only worthless stock options left behind.
It’s all about the timing, which is one of the downsides of stock options for employees who are not paying attention. Stock options have expiration dates and will be worthless if held too long. But deciding when to exercise before the options expire can be difficult as well.
According to the Bureau of Labor Statistics, about a third of new businesses fail in their first two years.
One camp says hold out as long as you can, waiting for the pinnacle price. On the other hand, you may risk waiting too long and missing the peak, or else exercise too early and miss more growth. There is no right answer. The circumstances will depend on your company, the market, or any number of things that you may not be able to predict.
Should You Opt for a Job With Options?
All else being equal, stock options are generally a great perk. While they offer the potential to amass great wealth, however, there’s also the potential for frustrating disappointment. If you accept a job with stock options, it is helpful to ask the human resources representative if there is any guidance or advice to help sort out stock options for employees.
The information contained in this article is not legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law.