Stock Options Explained: Types & How it Works

As a startup founder, you would agree that attracting and retaining top talent is a constant challenge. A way to address this issue is the use of Employee Stock Options (ESOs), which are becoming a common element in compensation packages at startups. This is because ESOs incentivize employees to work towards the company's success while also reducing upfront cash costs for the startup by allowing for lower base salaries.

This blog explores everything about stock options, including their types, important terms, tax treatment, etc. 

What are Stock Options?

Employee Stock Options (ESOs) are a form of equity compensation that companies extend to their employees and executives. Herein, instead of directly allocating shares of stock, companies provide options on the stock.

ESOs function like call options, granting the employee the privilege to purchase your company's stock at a pre-determined price within a set timeframe. The specifics of ESOs are detailed in an employee stock options agreement; however, unlike standard listed or exchange-traded options, ESOs generally cannot be sold.

The true value of your stock options becomes clear when your stock price goes above the exercise price of the call option. In such scenarios, call options are exercised, and the employee acquires the stock at a reduced rate. The employee then has the choice to either sell the stock immediately on the open market for a profit or retain the stock over a period.

How Do Stock Options Work?

Understanding the workings of ESOs is important for employers as well as employees; here is how stock options work:

• Grant: This is the initial stage where stock options are awarded to employees. The exercise price, which is also known as the strike price, is set at this point and is usually equal to the stock value at the time of the grant. This price is what employees will pay to purchase the shares in the future.
• Vesting: Vesting is the period employees must wait before they can exercise their options. It can be time-based, requiring employees to stay with the company for a certain period, or performance-based, depending on the achievement of specific goals. 

Additional Read: What Is Cliff Vesting And How Does It Work? 

• Exercise: Once the vesting period is complete, employees can exercise their stock options, meaning they can purchase the shares at the exercise price. Some companies allow early exercise of unvested options, providing options to the employee to save tax but at an upfront cash outflow.
• Sale: After exercising the options and acquiring the shares, employees can choose to sell them. They can sell immediately or hold onto the shares for a potentially higher future value. The timing of the sale will determine the tax treatment, affecting whether gains are taxed as short-term or long-term capital gains.

Benefits of Stock Options

Here are the advantages offered by stock options for employees as well as employers:

Benefits for Employees

• Financial Rewards: Stock options offer employees the potential for significant financial gain if the company performs well. Unlike cash bonuses, equity-based awards like stock options can result in impressive returns on investment, making them a compelling benefit.
• Control Over Exercise Timing: Stock options give employees control over when to exercise their options. This flexibility allows them to strategically decide the exercise date based on the company's performance and their financial situation to maximize the benefits.
• Tax Advantages: Certain types of stock options, such as Incentive Stock Options (ISOs), offer tax benefits. When employees exercise their stock options, they do not have to report any income for regular tax purposes immediately, but they might still be subject to the Alternative Minimum Tax (AMT). If they retain the shares for a certain period before selling, they will only be taxed on the profit they make from the sale. This tax, known as long-term capital gains tax, is usually less than the regular income tax rate.

Additional Read: IRS Form 3921: What is it and How to File?

Benefits for Employers

• Improved Retention: Stock options can improve employee retention by providing long-term incentives. Since most stock options vest over several years, employees have a financial incentive to stay with the company to realize the full benefits.
• Flexible Compensation Tool: Stock options offer a flexible compensation tool that can be customized to fit the company's needs. Non-qualified stock options (NSOs) have a straightforward tax structure, making them easy to administer and communicate to employees.
• Competitive Edge in Talent Acquisition: In competitive job markets, offering stock options can give your company an edge in attracting top talent. The potential for significant financial gain from stock options can help you compete for the best talent, even if you cannot match the salaries offered by larger companies.
• Ownership Mindset: Stock options provide your employees with a stake in the company, encouraging them to think and act like owners. This alignment with the company's mission can lead to more thoughtful decision-making that benefits your business.

What are Stock Option Grants?

Stock option grants are the means by which companies award stock options to their employees. These grants provide all the details of the equity plan, including how and when the equity will be granted. Here are the essential elements of a stock option grant:

• Grant Date: This is the date when your company grants the stock options to the employee. It marks the beginning of the stock option lifecycle.
• Number of Options: This refers to the total number of stock options that have been granted to employees. Every option represents the right to purchase shares of your company's stock.
• Type of Options Granted: The grant will indicate if the ESOs are Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs), each with different tax effects for the employee.
• Expiration Date: This is the date until which the employee can exercise their options. After this date, the options expire and can no longer be exercised.
• Exercise Window: This refers to the period during which the employee can exercise their options. It usually begins after the vesting period and ends on the expiration date. This window gives employees flexibility to decide when to exercise their options. 
• Other Details: The grant may also include other details such as the vesting schedule, early exercise provisions, and terms related to employment termination or company sale.

What are the Tax Implications of Stock Options?

The tax treatment varies depending on the type of options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). Here are details related to their taxability:

Incentive Stock Options (ISOs)

ISOs offer potential tax advantages as they are not taxable at the time of granting, upon vesting, or while exercising. However, the differential amount between the exercise price and the Fair Market Value (FMV) at that time is considered a preference item for the AMT, leading to potential AMT liability in the year of exercise. If an employee holds the shares for at least one year after exercising and two years after the grant date, the sale of the shares is taxed at the (lower) long-term capital gains rate.

To qualify for favorable tax treatment under the IRC, the total FMV of ISOs that become exercisable for the first time in a calendar year cannot exceed $100,000. This limit is based on the fair market value of the stock on the ISO grant date.

Non-Qualified Stock Options (NSOs)

There are no tax consequences when NSOs are granted or vested. When employees exercise NSOs, the price difference between the exercise price and the current FMV is treated as ordinary income, which is subject to income tax, Social Security, and Medicare taxes. This amount is also reported on every employee's W-2 form. 

When employees sell the shares, any gain or loss is considered a capital gain or loss. If they hold the shares for more than one year after exercising, the gain is taxed at the (favorable) long-term capital gains rate. Unlike ISOs, there are no restrictions on the total value of NSOs that can become exercisable in a year.

Important Stock Options Terms You Should Know

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Here are the critical dates and terms you should be familiar with:

• Grant Date: This is the date when your company grants the stock options to the employee, and it marks the beginning of the vesting period. On this day, the terms of the stock option grant, including the number of options and the strike price, are established.
• Vesting Schedule: This refers to the timeline that dictates when an employee becomes eligible to exercise their options, which can be time-based, performance-based, or a combination of both. A typical schedule might have a cliff vesting period followed by monthly or annual vesting.
• Exercise Date: This is the date when an employee chooses to exercise their options and purchase your company's stock at the predetermined strike price. The time of exercise is crucial because it triggers potential tax liabilities and starts the clock on holding periods for tax purposes.
• Expiration Date: This is the last date by which the options can be exercised. If options are not exercised before this date, they expire and become worthless. This is typically 10 years from the grant date but can vary depending on your company's plan.
• Strike Price: Also known as the exercise price, this is the amount an employee pays to buy the company's stock through their options. Usually set at the stock's market value on the grant date, the strike price is crucial in determining how profitable option exercising will be.
• Fair Market Value (FMV): It is the current value of your company's stock and is assessed based on market conditions and company performance. FMV is crucial for determining the strike price at the grant date and the tax implications when employees exercise the options.

Additional Terms

• In-the-money: This term is used when the stock's FMV is higher than the strike price, making it profitable to exercise the options.
• Out-of-the-money: This term is used when the stock's FMV is lower than the strike price, making it unprofitable to exercise the options.
• Underwater options: This term refers to out-of-the-money options. If options are underwater, employees may choose not to exercise them.

What are the Different Types of Stock Options?

Beyond traditional stock options, the following are the other types of equity compensation that you can use to incentivize your employees: 

Employee Stock Purchase Plans (ESPPs)

An Employee Stock Purchase Plan (ESPP) enables your employees to purchase company stock at a discounted price. They have to contribute to ESPPs through payroll deductions, which accumulate until a designated purchase date. On this date, your company will use the collected funds to purchase shares on behalf of the participating individuals.

ESPPs offer several benefits to employees, such as the opportunity to own a stake in the company at a discounted price, often 5%- 15% off the FMV. ESPPs can offer favorable tax treatment if they qualify as 'Section 423' plans. If certain conditions are met, the gain on the sale of ESPP shares can be taxed at the lower long-term capital gains rate.

Restricted Stock Grants

Restricted Stock Grants are a form of equity compensation where your company can grant shares of the stock to an employee. However, these shares are subject to certain restrictions, including a vesting schedule, and employees gain full ownership of the shares only after the vesting requirements are met. Vesting schedules can be time-based (e.g., 25% of the shares vest each year over four years) or performance-based (e.g., shares vest upon achieving specific company goals).

Restricted Stock Grants represent actual ownership from the start; they have value even if the company's share price does not increase. Employees are taxed on the value of the shares when they vest. However, under Section 83(b) of the IRC, employees receiving restricted stock can elect to be taxed on the FMV at the time of grant. This can result in a lower tax bill if the stock price increases between the grant date and the vesting date.

Phantom Stocks

Phantom Stocks are a unique form of incentive compensation in which employees can receive the benefits of owning a stock without your company actually giving them the stock. Instead of physical stock, the employees receive 'mock stock' that tracks the price movements of your company's actual stock.

Phantom Stocks offers several benefits to both you and your employees. They provide a way for you to incentivize key individuals without diluting the equity of existing shareholders or making employees direct owners. Employees enjoy a potential for significant financial gain if the underlying stock's price rises without the need to invest their own money.

Stock Appreciation Rights (SARs)

Stock Appreciation Rights (SARs) are a form of employee compensation tied to your company's stock price over a specific period. Unlike traditional stock options, SARs do not require individuals to pay an exercise price upfront. Instead, they receive the monetary equivalent of the stock's price appreciation.

SARs provide employees with the right to receive cash equivalent to the increase in the company's stock price over a set timeframe. While these bonuses are typically paid in cash, some employers may offer them in company shares. This approach benefits your company by avoiding the dilution of existing shareholders' equity that would occur with the issuance of additional shares.

Conclusion

Understanding ESOs and their potential impact on employee compensation and company success is crucial for startup founders. However, managing stock options can be a complex task, requiring a deep understanding of various types of options, tax implications, and key terms. This is where Qapita comes in as a reliable partner for equity grants management.

At Qapita, we are rated as the #1 Equity Management Software by G2. Our equity management platform handles capitalization table management, Employee Stock Ownership Plan (ESOP) management, and digital ESOP issuance, helping equity stakeholders digitally manage their holdings efficiently.

With Qapita, you can easily handle all your equity matters from inception to IPO. Our platform and interactive employee sessions on communicating ESOPs effectively to employees have proven to be very helpful. Over 2,400 rapidly growing companies are already benefiting from our platform.

So, whether you are a founder looking to design an effective equity compensation plan or an employee trying to navigate your stock options package, Qapita can be your trusted partner in this journey. 

Contact us today to learn more about our services.