Lots of startups and tech companies have taken to offering their employees stock options, or ESOP (employee stock option plan), alongside their salary. It’s both a way to provide a bigger potential payday for employees, and a way to incentivize them to help the company succeed.
Stock options sound exciting, but they can also be confusing. There are terms like exercise, vesting, and liquidity events, and rules around when you can do what. Let’s cut through a bit of that confusion and walk through exactly how company stock options work.
A stock option is a term used in more than just employment scenarios. Traders and investors also often deal with stock options, which give someone the right, but not the obligation, to buy a stock at a set price.
Let’s imagine instead of stocks you’re shopping at a store. The shop owner promises you that next week a shipment of new laptops is coming in, and they’re going to let you buy one for 500 euros, no matter what the actual price of the laptop is. You don’t have to buy the laptop of course, but it might be a good deal for you if you do.
That 500 euros for the laptop is called a strike price. It’s the agreed-upon price at which you can buy your stock. This strike price can depend on a lot of things, but is usually tied to when you started at the company, or when you buy it. When we talk about stock options, we say exercise instead of buy. You exercise the option, and through that buy the stock, but you’re not buying the option.
That’s one of the major differences between a salary and an ESOP. If your employer offers an ESOP, you’ll have to spend money upfront in order to potentially make money later on. The strike price can be low — but you still have to pay it.
There are some exceptions here — sometimes employers will allow you to pay for your stock options with your stock options, or they’ll give them for free. This is an area where you should talk to your company directly. In the most basic form, stock options always have a strike price.
Usually, you don’t get to buy all the stocks a company offers you at once. Instead, options vest — they become available to you. The most common way to do this is to offer you a portion of your total shares each year. If the company offers you 100 shares in total, they might let 25 vest every year, so you get the opportunity to buy 25 shares every year. That way, they incentivize you not to leave before you’d had a chance to buy all your shares.
An important note: you don’t need to buy your stock the second it vests. You can buy it after that point, and in whatever amount you want, up to the vesting amount. If you haven’t managed to buy all the options available to you before the next batch vest, you’ll just have more options available to you then.
We’ve talked about the strike price of options. This is where the real value of stock options come in. In the example of the laptop, the strike price was 500 euros. But the laptop itself might be worth 700 euros. In that case, there’s a spread — a difference in value between what you paid and what you can resell the item for.
The shares you gain through stock options usually have a spread. If your company is public, and its shares already trade on stock exchanges, you might get the right to buy shares below what they’re currently trading for. If your company is private, especially if it’s a startup, the strike price might depend on the latest valuation of the company. As the company grows, and the valuation goes up, the value of your shares increases, as does the spread.
There are sometimes rules on when shares granted through stock options are allowed to be sold, especially if your company is private. That’s where liquidity events come in. These are times when you can sell the shares you’ve bought with your options. Often, this is an IPO, when the company’s shares start trading on a stock exchange and everyone is able to buy and sell them. It can also be an acquisition — when the company gets bought and the acquirer buys all your shares for an agreed-upon price, or a merger, when something similar happens.
At this point, the amount of money you make is dependent on your spread. If everything went well, the value of the share is higher than what you paid for it, and you can sell it for a profit.
Like any benefit a company gives you, there are tax implications on stock options. What kind depends on the kind of options you have. This is something best discussed with your company. But generally, you almost always have to pay tax when selling your shares, and often when you exercise your options.
Your company will often withhold income tax when you exercise your option. How much tax is deducted here depends on the kind of option you have. Non-qualified options usually don’t get a favourable tax rate, while incentive stock options might be exempt from tax when you exercise. There are also restricted stock units, which have their own peculiarities but are very similar to stock options.
When you sell your option, you’re usually responsible for the tax on the profit, or capital gains tax.