As part of your executive compensation package, you may be offered stock options. These contracts give you the right to buy shares of your company’s stock in the future at a pre-determined price.
“Loosely, stock options are a deferred method of compensation, especially popular in tech companies and for executive-level positions,” says financial planner Luke Chapman, a partner at Precision Wealth Partners in New Castle, Del. “They tie your future earnings to the overall growth and well-being of the company, so everyone is swimming in the same direction.”
Since the Great Recession, corporate boards have been more eager to tie compensation for their executives to the long-term performance of the company, with stock options being a popular way to do so. The National Center for Employee Ownership estimates that nine times as many employees hold options as they did in 1990. For top executives, the value of stock-options contracts can outweigh what they earn in salary.
Stock options as executive compensation do take some extra planning compared to simpler forms of pay, such as a cash bonus or a 401(k) match. Here’s what you must know to maximize the value of your stock options:
How Do Stock Options Work as a Form of Executive Compensation?
In a stock options contract, your employer agrees to let you buy a number of shares of company stock at a pre-set price — say, as many as 2,000 shares at $50 a share. It doesn’t matter what the stock’s actual market price is when you ultimately take advantage of the contract; your employer must sell the shares to you at the agreed-upon price. If the stock’s market price — say, $100 a share — is above your stock options price, you can turn around and immediately sell your shares for a gain.
When, How to Exercise Your Stock Options
Employers may vest your executive stock options gradually over time — say, 20% of the allotted shares each year until the contract fully vests after five years. Other companies may vest executives’ stock options all at once — but not until several years of service, leaving you with nothing if you leave the company sooner.
Once your stock options have vested, you can exercise them. Of course, you must first come up with the cash to buy the shares. Remember your hypothetical contract for 2,000 shares at $50 per share? You would need to spend $100,000 to buy all of them, plus any trading commissions and fees for the transaction.
“To cover these costs, executives usually sell some or all the shares immediately versus paying for everything out-of-pocket,” says Chapman.
When to Sell Your Company Stock
If you think the share price will keep going up after you’ve exercised your stock options, you can keep the exercised shares in your portfolio, just as if you had bought them off the stock market.
However, beware having too much of your company’s stock in your portfolio. “Remember Enron. Those shares ended up worthless. It’s safest to diversify your investment portfolio and not to leave too much wealth in one company’s stock,” says Chapman.
What Happens When Stock Options Expire?
Options contracts do not last forever. They will have an expiration date, often 10 years from the day you receive the contract. And if you leave the company, you usually will have a small window of time to exercise your stock options. It’s not unusual for high-net-worth clients with stock options worth more than $100,000 approaching their expiration date to scramble to exercise the options in time, Chapman says.
Stock Options at Publicly Traded Companies
Stock options at publicly traded companies are easier to value and exercise. Since the stock is already publicly traded, you can easily assess the opportunity to sell shares at a profit on the market. Executives with vested stock options can wait until the stock’s market value is above the exercise price, known as “being in the money.” As soon as you exercise, you can turn around and immediately sell some or all your shares on the market without delay.
Stock Options at Private Companies and Startups
If you receive stock options at a private company such as a startup, they’re basically worthless until the company has an IPO and goes public. Don’t pay to exercise them prematurely. As long as the company remains private, there isn’t an open market to sell your shares. And there’s no guarantee a private company ever will go public.
How Are Stock Options Taxed?
Exercised stock options for executives are a form of compensation, which means the IRS is going to want their piece. The taxes you’ll owe depend on the type of contract: non-qualified stock options (NSOs) versus incentive stock options (ISOs).
With NSOs, you owe tax when you exercise the contract and potentially once again when you sell the shares. First, when you exercise the contract, you owe regular income tax on how much the market value of the stock exceeds your exercise price. If the market price is $100 a share and you exercise at $50, you would owe income tax on the $50-per-share difference.
If you hold onto the shares and if the price goes up even more, you’ll owe capital-gains tax on any appreciation when you sell. To qualify for the lower long-term capital gains rate, you must hold shares for at least a year before selling. Otherwise, the gains are taxed at the higher short-term gains rate, the same as your income-tax bracket.
With ISOs, you won’t owe income tax when you exercise your options to acquire shares — only when you sell the shares. You’ll owe long-term capital-gains tax on the difference between the exercise price and the market price when you sell. To get this favorable tax treatment, you must hold onto the shares for two years from the day you received the contract and one year from the exercise date. Otherwise, your ISOs will be taxed as NSOs.
For more help planning your options, consult with your financial advisor or accountant to make sure you maximize this form of executive compensation.