Employee Stock Options: Understanding the Benefits and Risks

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There's no shortage of legendary tales about workers striking it rich with employee stock options.

At Microsoft (MSFT), for example, the tech boom of the 1990s reportedly made approximately 10,000 employees millionaires – not just top executives, but everyday engineers, marketers and support staff who got in early and held on.

Of course the potential upside is obvious. But managing employee stock options is anything but simple. And the process can be challenging, according to a recent survey by the ESO Fund.

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Indeed, 67% of former startup employees said they felt only "somewhat" or "not at all" confident when it came to understanding and making decisions around their equity and knowing how and when to exercise their options.

Responses from a wide range of professionals – from engineers to sales reps to executives – underscore just how widespread confusion can be.

Let's take a look at what you should know if employee stock options are part of your compensation.

What are employee stock options?

Similar to regular options, employee stock options give you the right but not the obligation to buy a set number of company shares at a fixed price. This price is known as the "exercise price" or the "strike price."

The exercise or strike price is usually pegged to the stock's fair market value on the day the options are granted.

For example, suppose you join XYZ Widget and receive options for 1,000 shares with an exercise price of $10.

Sounds straightforward, right? But did you read the fine print about the vesting period?

You probably won't be able to purchase all those shares immediately.

"Most stock options come with a vesting schedule, meaning you earn the right to exercise a portion of your options over time," observes Ali Dhanji, a financial adviser at Raymond James & Associates.

"A common structure is four-year vesting with a one-year cliff," Dhanji explains, "where 25% of your options vest after one year, then the remainder vest monthly over the following three years."

Suppose you wait a year, and the stock price is $15.

You could exercise your 250 vested options at the $10 strike price for $2,500. If you sell the shares immediately at $15, you pocket $3,750. And you have a gain of $1,250 before taxes and fees.

Of course, the opposite can happen too. If the stock dips below your exercise price, the options are not worth exercising.

You'd be overpaying compared to the market, which is why these options are referred to as being "underwater." But all is not lost. You can hold on to it and wait, hoping the stock rebounds.

One more thing to keep in mind: Stock options don't last forever. Most come with a 10-year expiration window from the grant date.

And, if you leave the company, that window can shrink fast – typically to 90 days after your departure.

Miss that deadline, and your employee stock options expire worthless.

Types of employee stock options

There are two main types of employee stock options: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs).

ISOs are only offered to employees and come with a distinct tax advantage if you meet certain conditions. When you exercise ISOs, the difference between the stock's fair market value and your exercise price – the "spread" – isn’t taxed as regular income right away.

And you won't owe payroll taxes such as Social Security or Medicare either.

However, the spread does count as income under the Alternative Minimum Tax (AMT). This could mean a surprise tax bill, even if you haven't sold the shares.

To lock in the favorable long-term capital gains tax rate, you have to meet two key holding period rules:

1. Hold the shares for at least one year after you exercise; and

2. Wait at least two years from the original grant date before selling

If you sell too soon – before meeting both conditions – it's called a "disqualifying disposition." In such a case, the spread becomes taxable as ordinary income, and only any additional profit is treated as a capital gain.

Suppose you wait two years and 500 of your XYZ shares are vested.

You exercise them and pay $5,000. Because they're ISOs, you won't owe income tax immediately. But the $20,000 spread counts as income under AMT.

If you hold those shares for at least a year and sell them at $70, your $30,000 gain qualifies as a long-term capital gain.

But, if you sell earlier, the initial $20,000 spread is taxed as regular income, and only the extra $10,000 is treated as a capital gain.

NSOs are more flexible. They can be granted to anyone who provides services to a company, including employees, contractors and consultants. But they're taxed differently.

When you exercise NSOs, the spread is treated as ordinary income, reported on your W-2 if you're an employee or a 1099 if you're not. You'll also owe payroll taxes like Social Security and Medicare on that income.

Any gain or loss from holding the stock after that point is taxed separately as a capital gain when you eventually sell the shares.

Employee stocks options strategies

Given the tax complexities and the financial risks involved, it's important to seek the advice of a qualified tax or financial adviser when it comes to you and your employee stock options.

At the same time, you can start to think about some basic strategies.

"You can exercise ISOs in small amounts to avoid triggering AMT," said Trevor Ausen, a certified financial planner who runs Authentic Life Financial Planning.

"Each year," Ausen notes, "many people have room between their regular taxable income and Alternative Minimum Taxable Income (AMTI)."

Then there's the bigger picture. As your company stock starts to take up more space in your portfolio, the concentration risk grows.

It's generally wise not to let any one stock exceed 10% to 20% of your net worth, though that range can shift depending on your goals, age and appetite for risk.

Finally, you should negotiate the terms of your employee stock options.

"There is the dollar amount approach," said Scott Chou, co-founder and managing partner of the ESO Fund. "Multiply the number of options by the strike price, then compare that to your salary.

"Index Ventures suggests your four-year equity grant should fall between 25% and 100% of your annual salary."

Tom Taulli has been developing software since the 1980s when he was in high school. He sold his applications to a variety of publications. In college, he started his first company, which focused on the development of e-learning systems. He would go on to create other companies as well, including Hypermart.net that was sold to InfoSpace in 1996. Along the way, Tom has written columns for online publications such as Bloomberg, Forbes, Barron's and Kiplinger. He has also written a variety of books, including Artificial Intelligence Basics: A Non-Technical Introduction. He can be reached on Twitter at @ttaulli.