Know Your Life Options with Stock Options

There are many potential paths on the journey to building wealth. From investing over long time periods, to selling a business, to buying real estate, there’s no single way to navigate the road to financial security. For people who help a company grow, stock options can be a very rewarding — but sometimes twisting and turning — route to wealth creation.

Stock options are a tool that some companies use to align an employee’s compensation with the rising stock price of the company. They became extremely popular in the 1990s and are still used today.

In our Money Tales podcast with guest Jennifer Risher, she discusses how stock options helped her family build wealth during the tech boom. Jennifer worked at Microsoft in the early 1990s, where she met her husband. When they were expecting their first child, her husband decided to go to work for a startup online bookseller. As a result, they walked away from valuable Microsoft stock options in exchange for stock options at a lesser-known startup: Amazon. As you may have guessed, that risky decision worked out well.

As in Jennifer’s case, stock options can be an amazingly rewarding compensation tool. But they can also be extremely complicated as you navigate tax-related decisions for determining when to exercise stock options and when to sell the resulting shares of stock. My colleagues examine these decisions, as well as the differences between incentive stock options (ISOs) and nonqualified stock options (NQSOs), in 3 Strategies for Exercising Incentive Stock Options. Another popular type of equity compensation is restricted stock units, which are explained in detail in Restricted Stock Units (RSUs): What You Need to Know About Taxes, Selling Shares and Long-Term Strategies.

For those of you who have stock options — or who may be considering them as part of a compensation package — I define some key terms below and dive into how stock options are valued. Finally, I’ll highlight some factors to consider when dealing with some of their complexities.

Defining some key terms

Before going forward, it’s helpful to explain some terminology around stock options. When stock options are granted to an employee, the grant letter will specify the terms of the grant. These include the strike price, the vesting period and the expiration date. These are key terms to understand, as they directly impact the value of stock options.

• Strike price — The cost that the employee must pay to exercise the stock options. It’s usually set at the price of the stock on the date of grant.
• Vesting period — The time period during which the employee must continue to work at the company to be eligible to exercise the stock option grant. Typical vesting periods are monthly, quarterly or annually, and vesting usually occurs over a one- to four-year period following the grant date.
• Expiration date — The date after which the grant may no longer be exercised. This can be up to 10 years after the grant date.
• Option spread — The difference between the amount you paid for the stock options and their price of the vested shares at a particular point in time (before income taxes).

How stock options work — a closer look

Let’s look at an example to see how stock options can become valuable over time. To make this analysis easier to follow, we make a number of assumptions, although it’s good to remember that each case will be different and your situation may not correspond to this illustration.

First, we’ll assume that when you joined Company A four years ago, you were granted 10,000 stock options, and at the time, Company A’s stock was valued at $10 per share. This means that it would cost you $100,000 to exercise the full stock option grant — in other words, purchase all the shares at that price.

Second, assume that the grant vested annually over the last four years. This means that 2,500 shares became eligible for you to exercise each year. By the end of year four, all 10,000 stock options are fully vested and eligible to be exercised.

Finally, let’s assume that because the hard work of you and your coworkers, Company A is ready to go public. After the IPO, the company’s shares are now trading on the stock exchange at $100 per share. This means that your stock option grant is worth $1 million (or 10,000 shares multiplied by $100).

Remember, it would cost you $100,000 to exercise the grant, so the difference in value — the option spread — of $900,000 would be the amount of money you’d pocket before considering income taxes if you exercised the stock option and sold the resulting stock today. Being $900,000 richer (before taxes) is a nice reward for helping the company grow.

Appreciating the leverage built into stock options

Now let’s consider an alternate scenario where you don’t sell your stock because you are confident that the company will continue growing. Let’s presume that the stock price of Company A rises to $300 per share. At this price, the option spread would be $2.9 million — meaning that you’d walk away with this pre-tax amount. Again, we reach this total by multiplying the $300 share price by the 10,000 vested shares in your stock option grant, and then subtracting the exercise cost of $100,000.

In this example, the stock price increased 200%, going from $100 to $300 a share. But the stock option spread grew even more — to 222%. This is because of the leverage embedded in the stock option by its fixed strike price. You see, no matter what the future value of the stock is, the stock option strike price remains fixed.

It’s important to remember, however that not all stocks go up in value. If Company A’s stock price stayed at the $10 strike price or dipped below that amount, the entire stock option grant would be worthless.

Looking at stock options within a larger financial plan

Taxes are one of the biggest considerations when it comes to managing stock options. Other key questions to consider include:

• Are you reliant on the stock options to make your financial plan work?
• How many option grants do you have now? How many do you expect to receive in the future?
• Does the company pay a dividend?
• How long do you expect to continue to work at the company?
• How confident are you in the company’s future stock price?

Stock options can be a great boon for wealth creation. As you consider the various paths on the journey to wealth, the boulevard of stock options will likely include several twists and turns, and you may encounter some forks in the road along the way. That’s why any plan for managing stock options needs to start with conversations with your wealth manager and your tax advisor about your expectations, possibilities and what matters most to you.