Does your company offer you stock options. Or are you just confused by what they are. Well, a stock option is a financial instrument that gives you the right, but not the obligation, to purchase a given stock at an agreed-upon price and date. While we can get into a lengthy explanation of the differences between Put Options and Call Options, today we want to look at what your employer is offering you. Employee Stock Options (ESOs). These are a type of compensation that your employer will issue you (works like a Call Option), that are not traded in the stock market, and are restricted to just stock of a company given to their employees.
There are 2 main types of ESOs. Incentive Options and Non-qualified Options. Let's look at each.
- NQO's ( Non-Qualified Stock Options)
A non-qualified stock option is one methodology for a company to compensate key employees or others in an organization without having to actually pay them cash. They work best for employees within a company that has a rising stock price.
The company will grant the employee an option to purchase shares of stock at a fixed price. For example, Coke grants an employee 1,000 options at $65 which are good for 10 years. This means that the employee has the right over the next year no matter how high the stock prices goes to purchase 1,000 shares of Coke stock at $65. So, if Coke's stock goes to $95, then the option is worth $30 per share or $30,000 to the employee if exercised. All of these types of options will be taxed at ordinary income rates, which is a consideration that needs to be made at the time of exercising the option. When the stock isn't publicly traded, the company determines the value of a share of stock on the date the option is granted. The options typically lapse on a certain date which is predominately 10 years from the grant date.
- ISO's (Incentive Stock Options)
An incentive stock option (ISO) is a corporate benefit that gives an employee the right to buy shares of company stock at a discounted price with the added benefit of possible tax breaks on the profit. The profit on qualified ISOs is usually taxed at the capital gains rate, not the higher rate for ordinary income. Stock options are issued, or "granted," at a price set by the employer company, called the "strike price."
ISOs are issued on a beginning date, known as the grant date, and then the employee exercises their right to buy the options on the exercise date. Once the options are exercised, the employee has the freedom to either sell the stock or keep it.
Important: ISOs must be held for more than one year from the date of exercise and two years from the time of the grant to qualify for more favorable tax treatment.
For the employee, the downside of the ISO is the greater risk created by the waiting period before the options can be sold.
While not a Stock Option, since we are talking about employee stock, I thought I'd throw in Stock Purchase plans.
ESPP's (Employee Stock Purchase Plan)
An employee stock purchase plan (ESPP) is a company-run program in which participating employees can purchase company stock at a discounted price. Usually the discount is between 5 and 15%. Once purchased, there are no restrictions. You own the stock and can do whatever you want with it.