5 Steps to Evaluate Your Employee Stock Options

Vijay Patel
August 9, 2022
Written by

Evaluating your compensation package as a tech professional can be complex, especially when it comes to understanding employee stock options.

You need to assess what exactly is being offered, what factors you should consider, and how your actions (or inaction) can impact your ability to achieve long-term financial goals.

Here are 5 steps to help guide you and give you confidence as you think through your stock options strategy.

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1. Do I have stock options as part of my compensation package?

It may seem simplistic, but first you need to confirm that you are actually being offered stock options in your benefits package.

Stock options are often confused with restricted stock units, or RSUs, and they must be thought about and managed differently.

If you are unsure whether you are being offered RSUs or stock options, it might help to think about your company. Is it a well-established public company? Or a private start up? 

Most publicly traded companies like Google or Apple offer RSUs to employees, not stock options. Conversely, we most often see employee stock options offered at private or start up companies.

That being said, if your company has recently gone public, you may still have stock options that you have not yet exercised.

2. Do I have NSO or ISO stock options? Or both? 

Once you’ve established that you do have stock options as an employee, it is important to determine if you have Non-Qualified Stock Options (NSOs) or Incentive Stock Options (ISOs).

You may also have both types, especially if you have changed companies or jobs recently. Even if you have stayed at the same employer, it is common for startup companies to offer additional incentives to employees year after year, changing up the type of stock option granted. 

3. What are the grant, vesting, and expiration dates for my stock options?

Once you’ve determined what kind of stock options you have (NSO, ISO, or both), it is crucial to understand the grant, vesting, and expiration dates for each share offering.

At this point, it is important to familiarize yourself with some key terms:

  • Grant Date - This is the date that you are given the stock option shares. Typically following a four year “vesting period,” the grant date starts the clock for both the vesting dates and the expiration dates of your options.

  • Vesting Dates - Your vesting schedule will typically run four years from the grant date, and your shares will vest in increments. We typically see a schedule where 25% of your options will vest each year with the full 100% vesting after the fourth year at the company.
     
  • Expiration Date - Typically 10 years from the original grant date, the expiration date is the point at which the employee “loses” the ability to exercise or act on the stock options.

  • To “Exercise” an Option - To act on or exercise an option means to purchase the shares of stock per the agreement. Employees typically may only exercise the option or purchase stock shares that are vested.

  • Strike Price - The strike price is the predetermined agreed upon price to purchase the shares at the time of the grant date. Regardless of what happens after the grant date, the employee has the option to exercise the option or purchase shares at this price before the expiration date.

Here’s an example to put it all together:

You start in 2022 at a start-up private tech company, and you are offered 1,000 shares at a $1 strike price per share. The options are ISOs, or incentive stock options. You have a 4-year vesting period, where your shares will vest at 25% each year. Your options have 10 years before the expiration date.

Tech Professional Example - Incentive Stock Option

July 1, 2022 Grant Date
1,000 shares at $1 strike price
July 1, 2023 25% of the shares vest and can be exercised at $1 strike price
(up to 250 of your 1,000 shares)
July 1, 2024 50% of the shares are now vested and can be exercised at $1 strike price
(up to 500 of your 1,000 shares)
July 1, 2025 75% of the shares are now vested and can be exercised at $1 strike price
(up to 750 of your 1,000 shares)
July 1, 2026 100% of the shares are now vested and can be exercised at $1 strike price
(All 1,000 of your original 1,000 shares)
July 1, 2032 Expiration Date
All of your 1,000 shares must be acted on by this date or you "lose" the options

 

The question is, at the original $1 strike price, should you exercise your options at the 4-year mark? Or wait until right before the expiration date? Or sometime in between?

If you exercise the options at a private company, how confident are you that the company is going to go public so you can sell those shares? If your start-up doesn’t make it, you are now sitting on purchased shares that you can’t sell, and depending on the type of stock option, you may have tax liabilities that need to be paid in the next tax year.

Speaking of taxes, what else should you consider about all the potential tax liabilities for each type of employee stock option? If you exercise your options and have to claim the income on the next return, but can’t sell the shares publicly, is your salary and cash compensation enough to cover your tax liability?

Not to mention, this is only one grant, vesting, and expiration cycle. What if you’re offered another set of stock options? And another? It is not uncommon for tech professionals to be juggling multiple stock option incentives with different grant and expiration dates. What should you consider in keeping track of these multiple cycles?

Let’s dig into the details.

4. What is the most important difference between NSO and ISO stock options?

The most important difference between Non-Qualified Stock Options (NSOs) or Incentive Stock Options (ISOs) comes down to tax implications and liability.

NSOs are taxed as ordinary income (like W2) when exercised, and ISOs are only taxed when the exercised shares are sold (taxed on short-term or long-term capital gains, see below).

Thinking of the option above, where the employee was given 1,000 shares with a $1 strike price per share at the grant date, the employee can exercise 100% of the vested shares starting the 4th year.

If the stock option is an NSO, or Non-Qualified Stock Option, the employee will be taxed immediately upon exercising those shares as ordinary income. In our example above, let’s say the employee chooses to exercise all 1,000 shares at $1 share. Your tax will depend on the delta or difference between the fair market value of the share and your original strike price. Let’s say the fair market value was $10/share. The delta between your $1 strike price and $10 market value is $9. You will be taxed for that gain of $9/share as new income on your next tax return.

If the stock option is an ISO, or Incentive Stock Option, the employee will not be taxed upon exercising*. It will not count as ordinary income that will need to be paid for that year. The exercised shares will only be taxed at the time of a future sale.

*Note: Another wrinkle to consider: While the ISO exercised options will not be taxed as ordinary (W2) income, it will still impact your AMT liability for that year. AMT is essentially a secondary tax calculation, the “excess amount” of tax owed under the regular income rules. It doesn’t impact everyone, but it is another important consideration for employees to consider before exercising their ISO shares. Depending on the number of options exercised, this number can be significant and should factor into your thought process.

Capital Gains: In thinking about your tax liabilities and implications, an understanding of “capital gains” is important. Capital gains refer to the “gain” or increase in a share’s value at the time of the sale. A short-term capital gain is when the option is exercised and stock is sold within a 1 year period. The tax owed on a short-term capital gain is counted as ordinary income, which is greater than taxes that would be owed on a long-term capital gain. Long-term capital gains kick in after a stock has been “held” for one year or longer.

This is relevant for both the NSO and ISO options. You will owe tax liabilities for capital gains on both NSO and ISO stock options. You just technically will not have to pay taxes initially for exercising the ISO options (excluding the potential for AMT liability).

ISO

NSO

  1. At Grant - no tax event
  2. At Exercise - no tax event*
  3. At Sale - Capital Gain Tax owed
    1. Short-term for less than 1 year held (taxed as ordinary income)
    2. Long-term for more than 1 year held

*Subject to AMT Liability

  1. At Grant - no tax event
  2. At Exercise - spread taxed as ordinary income (W2)
  3. At Sale - Capital Gain Tax owed
    1. Short-term for less than 1 year held (taxed as ordinary income)
    2. Long-term for more than 1 year held

 

Private Companies: If you are at a private company, in thinking about whether or not to exercise your ISO or NSO options, there are more questions you need to answer before making this decision. For one, it can be more difficult to sell your shares, unless one of these three things happens:

  • Your company offers an internal liquidity event where it buys back shares from you
  • Your company goes public
  • Your company gets acquired, and the acquiring company buys your shares back

If one of these three things doesn’t happen, it’s important for you to consider: how will you pay for the taxes if you can’t sell the shares? 

You also should think about your next year or few years: can you afford to have money tied up in your shares that you cannot easily access?

5. How should I handle my stock options based on my long-term financial strategy and objectives?

Knowing the ins and outs of the different stock options and how they are taxed can help you make decisions that align with your long-term objectives.

Sometimes exercising your options early, even if it's an NSO (ordinary W2 tax) type of option, turns out to be the right decision. You start the clock on long-term capital gains earlier and pay less ordinary income tax in the future, allowing you to have potential benefits down the road. Your company goes public, you sell the shares at a fair market value price much higher than your original strike price, and you only have to pay long-term capital gains tax.

Sometimes it’s not. You exercise the NSO stock option, pay the ordinary income tax, and then you are left with private shares that cannot be sold or liquidated.

While nobody has a crystal ball, building a long-term financial strategy can help you make an educated decision. How do you feel about the start-up/private company? How much risk are you willing to take that they will go public? What is your cash situation like and other compensation benefits, and how can that help offset possible tax liabilities?

Having a strategic plan can help you evaluate your risk tolerance and provide much clearer direction about how to manage your options.

What Our Experience Tells Us

We’ve worked with tech professionals in Silicon Valley for decades and helped them navigate all of the various compensation options offered by startup and public companies alike.

The truth is, there are so many variables at play, and it can become burdensome to manage it all on your own. You don’t want to make a decision that puts you at a loss because you don’t have enough of a cash flow to cover a significant tax liability. At the same time, you don’t want to be so conservative that you miss out on maximizing your options and possibly benefitting tremendously down the road.

We encourage you to reach out to a financial advisor and talk through how they might help you navigate some of these complex situations.  You can always reach out to us and set up a complimentary consultation. In addition to stock options, we are well versed in handling other types of stock compensation benefits such as RSUs or ESPP.

Are you a tech professional? Take our quiz to find out if now is the time to start working with a financial advisor.

Topics: tech professionals, financial strategies

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