What to Do with Employee Stock Options?
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What to Do with Employee Stock Options?
Employee Stock Options, which are also called ESOs, are different from the mainstream stocks that you invest in.
These are probably one of the reasons why most early employees of large companies made money.
Nowadays, most people aren’t familiar with these stock options, and that’s why, I wanted to shed some light on this.
I will include all the detailed information about employee stock options and what to do with them.
Now, without any delay, let us take a dive into the topic for today, i.e., “What to Do with Employee Stock Options?”
To have a better understanding of these employee stock options, let us see the components of a salary package.
Table of Contents
Components of a salary package
A person’s salary consists of different components, which are listed below.
- Base Salary
The base salary, which is also known as basic salary or base pay, is a fixed amount paid to a person.
This fixed portion of salary is paid out to the employee on a regular basis.
Based on the firm, the base salary would be paid every month or bi-weekly.
The base salary in a salary package is not based on the salary of an individual and is consistent.
The bonus is an additional payment provided to employees based on individual’s or company’s performance.
It can either be discretionary or based on the performance, and generally paid annually, semi-annually, or quarterly.
This is only associated with sales or revenue-generating model jobs such as sales executive.
The commission is only paid on the basis of the sales or revenue generated by the individual.
- Overtime pay
Some may call it overtime or OT and is the pay offered for the additional hours worked by the employee.
In most countries, employees are offered overtime pay for the work hours in addition to the standard work hours.
These also fall under the category of additional pay along with the base salary offered to the employee.
There are different types of allowances that may be offered, and some of them include
— Housing allowance
— Transportation allowance
— Meal allowance
— Leave travel allowance
— Medical allowance
— Entertainment allowance
Based on the specific firm, the types of allowances that may be offered to the employee differ.
Benefits offered along with a salary include different types of non-cash compensation.
They commonly include:
— Health insurance
— Retirement plans
— Paid vacation
— Perks like gym membership, coupons, dental plans, etc.
Like allowances, benefits provided to the employees also differ from firm to firm.
- Severance pay
This is the pay offered to the employees when they leave the company because of reasons like downsizing, layoffs, etc.
Severance is a form of financial support offered by companies to help them during the transition period.
This is a mandatory year-end bonus after the employee works for a certain number of years with the company.
Employee Stock Options – What are they?
Employee stock options grant you the option to buy your employer’s stock at a specific price.
In general, these employee stock options are included in the employee’s salary package.
Employee stock options are either offered as a part of the incentive or an additional component of the salary.
These grant stock purchase access to the employees at a specified price for a specific time.
You should clearly understand that employee stock options are just the accessibility to buy stocks.
Shares are not directly offered to the employees under the employee stock options.
Whether or not to buy these stocks is dependent on the employee’s personal preference.
As I said before, they are completely different from stocks or index funds that you may be familiar with.
Why am I saying this?
Well, these stock options may not necessarily be available in the open market like exchange-traded stocks.
This means they aren’t available to all the investors like mainstream stocks, ETFs, or other investment vehicles.
So, employee stock options can be bought at a specified price, remember?
This means that they can be purchased at a discounted price for a particular time.
The main concept of these is to allow employees to buy into the company and grow the equity they have.
This creates a sentiment among the employees to work harder and maximize the profits earned by the company.
By working harder, they will not only improve the profits but also increase the value of their holdings in the company.
Employers can benefit from this as their employees work harder and in favor of their company.
The employers also find it a cheaper alternative to providing compensation to the employees.
How do they work?
Most countries offer ESOs as a part of the compensation package to their employees.
A few examples of the countries where you can commonly observe ESOs are as follows.
In most cases, the companies that offer ESOs to their employees are usually start-ups.
So, stock options are just the option for employees to buy stocks in the employer’s company.
They are not obligated to utilize or exercise the option to buy these stocks from the employer.
But when it comes to the utilization of these stocks, the specific terms on the utilization may differ.
In general, the specifics of these stock options are provided within the employment contract.
This means the contract specifically determines how many ESOs are received by the employees.
Here, we have to know a few details about vesting, which is important to understand ESOs.
When it comes to the context of employee stock options, vesting is a very important term.
When the employee gets stock options, they are not immediately exercisable.
Vesting of ESOs is the process by which the employee gets the ownership rights to the granted stock options.
When the stock options are received, they are known to be vested for a certain period, which is called the vesting period.
During the vesting period, the employee should be able to meet certain conditions.
Mostly, these conditions involve the employee to continue their employment with the company.
Once the conditions are met successfully, the employee is said to have vested in the ESOs offered, and then, they are exercisable.
There is a period known as the cliff period, and until its completion, the person cannot exercise the ESOs.
Let us have a look at an example for a better understanding of vesting and cliff period related to ESOs.
Example for vesting
Let us assume that a person named John is granted 2,000 stock options with a vesting period of four years. Let us say that the cliff period is one year.
Because the cliff period is one year, John cannot exercise the ESOs in the first year.
Following the first year, the employee is said to have reached the cliff’s end. By then 25% of the options, i.e., 500 options, become vested.
The remaining options become vested on a regular basis, which can be monthly, quarterly, etc.
This continues to happen until all the 2,000 options granted to John become vested by the end of the fourth year.
Key benefits of vesting
Given below are the benefits of vesting.
— With vesting, employees tend to remain with the company for the entire vesting period. Unless they do so, they can’t be able to benefit from the ESOs.
— The ongoing performance of the employee is associated with the company, which makes them work harder.
— Risks associated with employees leaving after they receive a substantial number of options are mitigated.
— Vesting allows employees to have a long-term vision for the company’s success as it is linked with the stock options granted to them.
The specific terms and conditions of ESOs are based on the vesting schedule.
What happens to the ESOs if the employee leaves before the ESOs are fully vested?
If an employee leaves the company before the ESOs are fully vested, they forfeit the unvested portion of the ESOs granted.
On the other hand, when the employee stays with the company during the vested period:
— Then can benefit from the potential capital appreciation of the stock options granted to them.
What happens if the employee leaves in the middle of the vesting period?
Remember John? Yes, the person from our previous example with the 2,000 options and four-year period.
If John wants to leave the company after two years, when the vesting of 1,000 stock options is complete, he gets to exercise 1,000 ESOs.
Nonetheless, John would still want to see the company succeed as it is beneficial for him.
Exercising stock options
What it means to exercise the stock options is outlined below based on the same example we discussed.
John can only have value to his ESOs if he wishes to purchase them while working there.
The price at which he can exercise the ESOs granted to him is laid out in the contract.
If John purchased the stocks at a discounted price, he is going to profit from the stock price increase in the future.
In the early stages of a valuable company, the employees are able to get equity at cheaper prices.
Types of Stock Options
The two main categories of employee stock options available for employees are:
— Incentive Stock Options (ISOs)
— Nonqualified Stock Options (NSOs/NQSOs)
The difference between these types of stock options is based on taxation.
Incentive Stock Options (ISOs)
Incentive stock options, or ISOs, offer special tax benefits when holding onto the shares for a certain period.
This tax treatment is generally offered at least a year or two after exercising the ESOs.
Therefore, you don’t have to pay taxes on the date you exercise your ESOs.
Nonetheless, when the employee fails to sell the stocks within one year after exercising them, there will be an alternative minimum tax.
Regular income taxes apply when the stocks are sold one year after exercising the ESOs.
Nonqualified Stock Options (NSOs)
With these stock options, the employees are required to pay taxes when they exercise and sell.
The taxation is done like regular income and the difference between the stock market value and the exercise price is to be paid.
Short-term capital gains tax incurs when the stocks are sold within one year after exercising them. Long-term capital gains tax is to be paid when they are sold after a period of one year.
Tax tips for ESOs
If you want to exercise your ESOs, it is very important to pay attention to the tax implications.
Given below are some tax tips for those who wish to exercise their ESOs.
- Understand the situation
Based on the type of ESO, the tax implications may vary, which is to be duly noted.
If you go ahead with ISOs and hold the stock, then you are subject to AMT.
However, NSOs come with taxes upon exercise as well as when you sell them.
Based on the specific type of ESO, you may be required to pay taxes that are associated with them.
- Same-Day Sale (Cashless Exercise)
With this method, you can avoid holding onto the stock after exercising it.
With this method, you can sell enough of the acquired shares to offset the cost of exercising the options and taxes.
By doing so, you may avoid paying short-term capital gains tax in the event of capital appreciation of the stock.
Let us have a quick example to better understand the same-day sale method.
Imagine that you got 1,000 ESOs from the company with an exercise price of $50.
Assume that the market value of those ESOs is $100 and you’ll be subject to a tax rate of 20% on ordinary income.
First, you must pay the exercise price multiplied by the number of options for exercising the options. Which is:
Exercise price of $50 * 1,000 options = $50,000
The next step is to calculate the gross proceeds from the same-day sale of the options.
1,000 options * (market value of $100 – Exercise price $50) = $50,000
The taxable income is the difference between the market value and the exercise price, which leads to:
1,000 options * (market value of $100 – Exercise price $50) = $50,000
Following that, you must calculate the tax liability, which is obtained by multiplying the taxable income and tax rate.
20% tax rate for $50,000 taxable income = $10,000
Now, it is time to calculate the net proceeds from the same-day sale method.
Net proceeds are obtained by subtracting the tax liability from the gross proceeds.
Gross proceeds of $50,000 – tax liability of $10,000 = $40,000
Finally, the remaining shares that you’ll have are obtained by subtracting net proceeds divided by market value from the number of options.
Total options of 1,000 – net proceeds $40,000/market value $100 = 600
Therefore, when you exercise all the options and sell enough of them to cover the taxes and exercise costs, you’ll have 600 remaining.
Please note that the example only consists of the tax for the normal tax rate. Based on the situation, there might be AMT, state taxes, etc.
- Pay attention to the holding period
The holding period determines whether you’ll be subject to short-term capital gains tax or long-term capital gains tax.
- Tax-advantaged accounts
It is possible to exercise your ESOs within tax-advantaged accounts like IRA or 401(k) in the US.
This could help you further reduce the taxes, which can be another good method for offsetting the tax liabilities.
- Seek professional advice
It is always wise to consult your financial professional before exercising your ESOs to get a better idea.
It might become hard to maintain accurate records and plan for the estimated taxes all by yourself.
Therefore, a professional can be helpful for you to exercise your ESOs in a much more efficient manner.
What to Do with Employee Stock Options?
Well, that’s the tricky question and I have the right answer for you. If you personally believe that your company is set to grow in the future, you can hold them.
Keep in mind that you’ll only be able to receive profits if the company performs well and the stocks increase in value.
- Wait for IPO
In general, it is advisable to be patient and wait for your company to conduct an initial public offering (IPO).
This is while assuming that the company has plans to go public.
Even after the IPO, it is prudent to hold off on exercising your options until the stock market price surpasses your exercise price.
If your company does not have immediate plans for an IPO, it is wise to wait.
Better to wait until there are any signs indicating an upward movement in the stock price before deciding to exercise your options.
If you believe in the long-term growth potential of the company and its stock, you can exercise ESOs.
- Buy and hold strategy
After exercising, hold onto the acquired shares until the stock value increases.
This strategy allows you to become a shareholder and potentially benefit from any future stock price appreciation.
Keep in mind the tax implications, especially if you have Incentive Stock Options (ISOs).
This is because holding the ISOs for a certain period may qualify you for favorable long-term capital gains tax treatment.
- Utilize Same-Day Sale (Cashless Exercise)
Some people need immediate liquidity or are concerned about holding onto a concentrated position in one stock.
If that’s the case, you can consider a same-day sale or cashless exercise.
With this approach, immediately sell enough of the acquired shares to cover the exercise cost and any applicable taxes.
By doing it in this way, you can realize a cash benefit without holding onto the stock.
- Sell to Diversify
Some employees have a substantial portion of their overall wealth tied up in the company’s stock due to ESOs.
In such a situation, you may consider selling a portion of the acquired shares to diversify your investment portfolio.
Diversification can help reduce risk by spreading your investments across different asset classes and sectors.
- Perfect Time to Exercise
If you are unsure whether the stock price may increase in the future, you can wait for a more opportune time to exercise the ESOs.
However, be mindful of any expiration dates on the options.
Ultimately, if you find yourself uncertain and facing a dilemma, seeking guidance from a seasoned tax advisor is recommended.
They can assist you in determining the optimal timing for exercising your options.
Consult with a Financial Advisor
Deciding what to do with your ESOs can be complex, especially considering:
— Tax implications
— Market conditions
— Your financial situation
— Your investment goals
Seeking advice from a qualified financial advisor or tax professional can help you make informed decisions.
Depending on your financial goals and risk tolerance, you may choose a combination of the above strategies.
For instance, you can exercise some ESOs and hold the shares while selling others to diversify or cover the exercise cost.
Whether Employee Stock Options (ESOs) are good or not depends on various factors
Such contributing factors may include your financial goals, risk tolerance, the financial health of the company offering the options, and the specific terms of the ESOs.
ESOs can be a valuable component of an employee’s package and provide the potential for financial gain.
However, they come with relevant risks and complexities that require careful evaluation and planning.
Before deciding whether to participate in an ESO program, it’s essential to fully understand:
— Terms and conditions
— Tax implications
— Potential risks involved
Seeking advice from financial and tax professionals can help you make informed decisions based on your circumstances and financial goals.
With that being said, I trust that the details provided in this article have been beneficial in knowing about ESOs.
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