What You Need to Know About Stock Options
What You Need to Know About Stock Options
Stock options, also known as share options, are a type of equity compensation companies can offer employees. There are two stock options: “non-qualified” and “incentive qualified.”
non-qualified stock option
The company grants an option to purchase shares of company stock to directors or executives who meet certain conditions set out in the corporate document–for example, minimum service and age requirements. The holder does not have any rights as an employee. Non-qualified options are taxed at capital gain rates for US residents and ordinary income rates for non-US residents.
incentive-qualified stock option
The option to purchase company stock shares that the company grants directors or executives with specific minimum service requirements can be exercised after the required service has been completed, usually at a predetermined date. The holder has all rights as an employee and ownership rights. These options are not taxed.
What You Need to Know About Stock Options
1. What types of options are available?
You have only two choices: incentive-qualified options or non-qualified stock options. While incentive-qualified options do not immediately impact your income tax liability, they affect your gain timing.
2. Are stock options expensive?
Typically, the exercise price of stock options is set at or near the current market value of the company’s shares. Exercise prices for incentive-qualified stock options are usually lower than for non-qualified stock options. According to Jordan Sudberg, a pain management specialist, the average cost of an incentive-qualified stock option ranges from $10 to $12 per share. The average cost of a non-qualified stock option is about $3 to $4 per share.
3. How many options can I receive?
According to Sudberg, you can only exercise your options after receiving a certain number of years’ vesting in incentive-qualified stock options. There are two standard vesting schedules: three-year and four-year. The three-year schedule requires that you be vested after three years’ service, while the four-year schedule requires that you be vested after four years’ service. Non-qualified stock options have no vesting schedule and can be exercised at any time on or before their expiration date.
4. How do my options vest?
Incentive-qualified stock options vest from 0% to 100% in three stages. You will own 50% of your incentive-qualified stock options at the end of the first year. A second 25% will vest at the end of the second year, while a final 25% will vest at the end of the third year. This is called a three-year schedule. Another option is a four-year schedule that requires that you vest 25% after each year for four years.
5. What happens if I leave the company?
With incentive-qualified stock options, you can exercise your options and sell them immediately or wait to exercise them at a later time. However, if you decide to exercise your incentives when you leave the company, you will have to pay income taxes on the difference in price between what it costs to buy the stock and what you sold it for. Non-qualified stock options can be exercised at any time with no tax implications.
According to Jordan Sudberg, stock options are precious instruments that benefit the individual and the organization. Understanding how to properly use them can only make you a better employee and, therefore, a better person. Stock options can only be used to benefit the owners, like you and me.
Many other factors impact your decision regarding stock options, including what type of option is used in a particular situation and whether additional top executives are granted these same options as part of an executive compensation package.