So, your company just granted you stock options. You may be wondering what they are, how they work and what you should do now.
First, let me congratulate you. Stock options may not make you rich, but if you don’t do anything crazy, they can’t hurt you.
Stock Options: Employee stock options are granted to key employees as incentives to help drive the value of the company up, which generally follows successful execution of the business plan. An option gives the employee the right — but not the obligation — to buy a share of company stock at a predetermined price (the strike price) for a term (usually five to 10 years). At the end of the term, if the option has not been exercised (used to buy stock) it expires worthless.
Why Is That a Good Thing? The right, without the obligation, to buy stock is a good thing because you are not required to make any investment, or to put any money at risk to participate in the increasing value of the company. For instance, if the strike price (the price at which you can buy shares of the company stock) is $1 and the stock price goes to $11, you have a profit baked in of $10 per share. If you were granted 1,000 shares, your value would be $10,000. That’s a good thing.
Income is Taxable: When you exercise your options, the I.R.S. generally takes the view that you’ve had a taxable event. The taxable income is the difference between the value of the stock and the strike price. In our example of an $11 share price with a $1 strike price the taxable income would be $10 — even if you don’t sell the shares. Because this income is on top of all of your other income, it will be taxed at your marginal rate, the highest rate you’ll pay in tax. That could easily represent one third of your option profit when you consider state and federal taxes.
Exercise When You Sell: Exercising (using your stock options to buy the stock) is a good idea only when you are ready to sell the shares of stock. Remember, even though your right to buy costs you nothing along the way, when you actually buy the shares, you will need to put up cash — unless you’re ready to sell. Just wait until you are ready to sell. Generally, your company will work with a broker to arrange for you to exercise the options without putting up the cash if you immediately sell the shares. You can use the cash to pay the taxes due.
Exercise at Expiration: The only other time to consider exercising your options is at expiration. If you can’t sell the shares (the company is private and there are no buyers) you may want to exercise your options, but do so with caution. If the options are about to expire and you are certain the value of the shares is much greater than the strike price, you may wish to exercise the options and buy the shares with your own cash. Remember, you’ll need to not only pay the strike price, you’ll need to pay the taxes, too.
Devin Thorpe, husband, father, author of Your Mark On The World and a popular guest speaker, is a Forbes Contributor. Building on a twenty-five year career in finance and entrepreneurship that included $500 million in completed transactions, he now champions social good full time, seeking to help others succeed in their efforts to make the world a better place.