Basic Concepts of Employee Stock Options

In the late 1990s, when the internet was blossoming, stock options were the major drawing card. Since that time, this card is bringing influential talent to many new up-and-coming companies. Stock options benefit both employers and employees. It is one of the best ways to offer a part of the future growth or a percentage of the wealth generated by the company.

Employee stock options have even replaced the necessity of providing added compensation to employees. Rather, money or cash could be saved & spent more wisely. As per various studies on new startups, many companies who do not offer the stock options have failed in the long run. And the younger executives were left with nothing but the worthless options. Today, most companies offer stock options as a part of a package and have typically added them as perks.

Let’s have a closer look at the basic concepts of Employee Stock Options (ESO.

An employee stock option (ESO) grants employees of a company with an opportunity to buy an amount of company shares at a fixed price for a particular number of years. It is slightly different from an exchange-traded option. It is not traded between investors on an exchange. In fact, it is a contractual right awarded by a company under a stock plan. The market price at the time the ESO is offered eventually becomes a grant price or the offering price for that particular option.

Within a specific period, the person may benefit from this allocated option whenever they choose. By doing proper stock market research, the information about the stock price may be obtained at any time. One can even purchase the shares at the grant price if the stock has gone up or may even sell them for a profit.  

Terminologies that you need to know about Employee Stock Options (ESO)

Employee Stock Option trading has its own vernacular. To understand the deeper concept of ESOs, you need to know about the option trading terminology. Let us speak more technically so that we can throw insight over this wide concept.

What is An Option?

An option is considered as a contract allowing a person or an employee to buy-(call option) or to sell – (put option) a specific number of the underlying stock at a specific price (strike price) for a specific period of time(any time prior to its expiration). Here is more in-depth knowledge about the different types of Options Trading Terminology.

What are the different Options Trading Terminology?

• CALL OPTION

A Call Option provides the buyer with an opportunity to buy shares at a fixed price (strike price). The offered shares can be bought before a specified date (expiration date). Moreover, the seller (writer) of a call option is bound to sell the stock at the decided fixed price or strike price (if the option is exercised).

• PUT OPTION

It is an option that provides the buyer the right to sell shares (unless adjusted for a split or other corporate action) at a fixed price within a specific period of time. Moreover, if exercised, the seller (writer) of a put option is bound to buy the stock at the fixed(strike price).

• STRIKE (OR EXERCISE) PRICE

This price is often referred to as the exercise price. It determines the per share price, at which a holder is allowed to sell (for put options) or can purchase (for call options) for the underlying stocks.

• EXERCISE

It is the process through which the terms of the option contract is invoked by an option buyer (holder). If exercised,  put option owners will sell the underlying stock while calls option holders will buy it under the terms & regulations set by the option contract. All in-the-money option contracts will be automatically exercised at expiration. ( *It should have at least one cent of intrinsic value).

• EXPIRATION DATE

Another critical Employee Stock Options terminology is the expiration date. It is considered as the last day any option may be exercised. Usually, on the third Friday of each month, stock options cease trading (monthly listed) and expire on the very next day.

• HEDGING

It is a conventional strategy that is used for reducing investments risk. Through this conservative Hedging strategy, a transaction is implemented that offsets an existing position.

• COVERED CALL

In employee stock options terminology, a covered call is considered as a call option. It is written or sold against an existent stock position. If a call option is exercised, the call could be delivered and said to be covered by the underlying stock.

• INTRINSIC VALUE

Employee Stock Options is all about benefits & profits. If the option is exercised, the total amount of profit that is theoretically obtained is called the intrinsic value of an option. And at the same time, the stock is either sold (for puts) or purchased (for calls) at the current market price.

If an option has negative intrinsic value it is said to be OTM or “out-of-the-money” and if it has a positive intrinsic value, we will say it to be ITM or “in-the-money. For instance, regardless of the market price at a particular time, an ABC January 20 Call may have an intrinsic value of  $1.50, if the stock were trading at $26.50.

• TIME VALUE

If the option’s market price exceeds its intrinsic value by a specific amount, it is defined as the time value.  If we consider the case as mentioned above, let the ABC January 20 Call priced at $3.00 when the ABC stock is trading at $26.50 with the intrinsic value of approx $1.50, then the remaining $1.50 would be the time value. In case the option has no intrinsic value or called to be as out-of-the-money, the whole market price is considered time value.

• PREMIUM

Premium is a terminology that describes the price of an option. These prices are quoted per share. The premium is considered as the entire dollar value of the option contract. (Total Premium = 100 Shares x Price/Share)

• TIME DECAY

As every option has an expiration date, all options could be considered to be the wasting assets. It is valid for the case when the time value erodes to zero by expiration and is often called as time decay. The time value changes with the square root of time. And the rate of time decay tends to increase if an option approaches its expiration date.

• LONG

To be “long” on an employee stock option simply means to purchase it in an opening transaction. Furthermore, it is considered to have purchased to own or hold it.

• SHORT

If an option is sold in an opening transaction, it is said to be “short”. Additionally, a short position is also taken as a negative on a statement. It is meant to be purchased later to close out.

• LEAPS

It is termed as Long-Term Equity Anticipation Securities. These are mainly the long-term options with certain expiration dates(as far out as three years) and usually expires in January.

Let us give a closer look at an example to understand how a typical ESO or employee stock option plan works

Let us assume, that on January 1st, 2019, you have been issued employee stock options. It has given you the right to buy around 2,000 shares of X company at a fixed price of $8/share. You are allocated with a time frame to buy the shares – January 1st, 2030.  Then in the middle of this time frame, on Christmas Day ( or could be any day), the X’s stock reaches $30 a share. This could also be the right time when you may decide to exercise your employee stock options:

• Your grant price is $8.00/Share
• The current market price is $30/Share
• Your issue date is  January 1st, 2019
• Your exercise date is December 25th, 2024
• Your expiration date is January 1st, 2030

You must buy the shares for $8,000 (1,000/Shares x $8/share), to exercise your stock options. Here are a few ways to do this:

• Pay cash

You can send this $8,000 to any of the reliable brokerage firm that could handle the options transaction. Later, you would receive 1,000 shares of X. You can either keep 1,000 shares or sell them.

• Cashless exercise

To cover the purchase price, you may exercise your options and decide to sell enough of the stocks. A brokerage firm could make happen both simultaneously.  Let us say you held with you the 500 shares of X, which you can keep for the future.

• Stock swap

For the 500 shares of X, you may send in a certificate. This certificate is equivalent to $8,000 at the current market price. And, this would be then used to buy 1,000 shares at $8 a share. In short, you are left with a total of 1,000 shares of X. You can either keep it or sell it as per your business strategy.

What are the types of Employee Stock Options?

There are two types of employee stock options, which companies issue to their employees:

• NQSOs – Non-Qualified Stock Options
• ISOs – Incentive Stock Options

Nonqualified Stock Options

NQSO is a type of stock option that does not pass for the favorable tax treatments that fall under the US Internal Revenue Code. Therefore, the word “nonqualified”  does not apply to the eligibility or any other consideration. It only applies to the tax treatment. It is one of the most common forms of stock options that are offered to the employees,  directors, consultants, contractors, and officers.

As an example, if the stock options exercise price is $8/share, and you decide to exercise them when the company’s stock price reaches $10/share, you will be left with a spread of $2  ($10-$08), and therefore, $2 becomes your ordinary income.

When you exercise NQSOs, your company will withhold the taxes like — Social Security, Income tax, and Medicare.

Your proceeds are taxed under the rules for capital gain and loss when you sell the shares. It will be taxed whether you sell them after a holding period or immediately. Furthermore, on your IRS Form 1040 tax return, you have to report the stock sale (under the Form 8949 and Schedule D  of IRS form).

Incentive Stock Options

Under the Internal Revenue Code, ISOs are qualified for special tax treatment. Incentive stock options are not subjected to Medicare,  Social Security, or withholding taxes. To qualify for this special treatment, they have to meet rigid criteria under the (IRC) tax code. Incentive Stock Options are never offered to contractors or consultants but are granted only to employees.

After you exercise ISOs, you may incur favorable long-term capital gains tax over the exercise price on all appreciation. It may happen if you either hold the acquired shares for one year from the date of exercise and at least two years (from the date of grant). However, you can be subjected to the alternative minimum tax (AMT) by the paper gains on shares received from ISOs (and if held beyond the calendar year of exercise). If you are hit with the AMT on theoretical benefits, this can be problematic. The company’s stock price can leave you with a large tax bill on income.

Take Away

For each type of options, different tax rules are applied. On non-qualified stock options, if exercised, taxes are mostly withheld from your proceeds. On the contrary, for incentive stock options, this is not necessary. The impact of exercising employee stock options can be minimized with proper tax planning.

There would be a mandate plan document for the employee stock options that dictates all the rules & guidelines associated with your options. You should hire a financial planner, who is familiar with these plans and may assist you in the right direction. Don’t forget to always keep a copy of this plan document and to give it a thorough reading.

There are various factors that may be considered while exercising stock options like – tax planning, investment risk,  and market volatility. However, personal financial circumstances would remain the most considerable factor, So you should not be influenced by someone’s personal advice.

How can Eqvista help You?

Now that you have understood the significance of employee stock options, you might be thinking to start offering some of the options from this very year. However, you would be required to make real-time updates, to stay compliant, and to manage and track your company shares. Recording and keeping track of your company’s shares is very important and can be a complex concept.

Fortunately, Eqvista has been developed with an idea to help entrepreneurs by making this process easy. It is a cap table software program that is designed specially to meet with all the requirements and manage your shares, to file the necessary reports with the government (if needed), and to keep a neat cap table. Give the Eqvista platform a try. To use this platform free of charge, register now!