Employee Option Grants

This discussion is about incentive stock options (ISOs), not non-qualified stock options (NSOs).

Strike Price and Exercising
An option is the right to buy stock at a given price, the “strike price.” If you receive stock options as part of your compensation, your offer letter might have specified the option package as “1,200 options to buy stock at a strike price of $2.00.” When you choose to exchange up to 1,200 of your options for stock, you write a check to the company for $2.00 per share of stock – in the lingo, this is called “exercising your options.” [I will continue using this example throughout this section.]

Vesting and Expiration
If a stock or option in your name is not vested, then it means that you currently lack the rights to that stock or option. You gain full rights to your stocks and options when they become vested, which usually happens over a vesting period rather than all at once. This is one way companies encourage their employees to stay. Employees who are confident that the company’s stock will someday be valuable might choose to stay with the company so that more of their shares will vest, thereby allowing them to sell a greater number of them in the future.

Your offer letter may have specified that “25% of your 1,200 options will vest one year from your start date, and 1/36 of the remaining options will vest each month for the following three years.” That means that 300 options will vest on the one-year anniversary of your start date, and that 25 options will vest each month after that. After 4 years, the number of options vested sums to 1,200. I have noticed that this vesting structure is fairly common in Silicon Valley.

Employee options packages often also have expiration dates. Ten years from your start date is fairly common. After the expiration date, you will no longer be able to exercise your options.

Tax Consequences of Exercising (ISO)
When you exercise an option, the good news is that you do not need to report any income. You will fill out a form 83(b) to send to the IRS, but that is to inform them on how to calculate your AMT, not to increase your taxable income for that year.

The bad news is that you need to report an AMT (alternative minimum tax) adjustment that may or may not require you to pay extra tax. The AMT was intended to ensure that a small number of rich people who benefit from certain tax breaks pay at least a minimum amount of tax, but it has actually been catching a more significant part of the population. While the Fairmark guide discusses certain AMT considerations, it does not specify any guidelines on who needs to actually pay AMT beyond that it “is a complicated calculation that may cause you to pay tax the time you exercise an ISO.” A general rule is that if you do not have a lot of deductions, like from a mortgage for example, or have a high regular salary, you probably don’t need to worry about AMT.

I have never filed AMT taxes before, but I imagine I will use a combination of Intuit’s Turbotax tool to calculate how much AMT I need to pay and H&R Block’s AMT estimator (the link is for 2006), as well as tips on avoiding AMT expenses like this.

“I exercised my option and now I’m holding stock. What happens when I sell it?…”
The Fairmark guide is very informative on issues of selling stock you received from exercising ISO, so please refer to that, particularly to the sections about the tax benefits of selling mature ISO stock. Note that there are also possible AMT consequences when you sell ISO stock, so go back to the resources mentioned above to estimate your AMT expenses.

What happens to my unvested equity if the company gets acquired?…
If your employment contracts stipulate that the unvested parts of your equity undergo “accelerated vesting” upon sale of the company, then you have probably made a good bit of money. Otherwise, you are screwed. Please check with your company administrators – or recruiters, if you have yet to accept an offer – about what will happen to your equity in this situation.

“How is the strike price of my option determined?”
The strike price on your stock options is determined to equal the stock price the day you the options are awarded. If the current stock price is $2.00 the day you join the company, then the strike price on your options will probably be $2.00. If you are joining a private company, this will be pretty straightforward since the stock price of a private company does not change very often. There is more gray area if you are joining a public company since the stock price fluctuates every day, and this is part of the reason for all the stock option scandals in the news, but this is not something you have to worry about unless you are in a position to make decisions about strike prices.

“How is the stock price determined at IPO?”
There is a whole field called corporate valuation that answers this question. Here is a online primer. I would say that this is not the most interesting question to keep asking at company meetings. I would say that this is not the most interesting question with which to badger management at company meetings because even the investment bankers don’t know until the last day before pricing.

“Where do options come from?”
Many companies keep a pool of employee stock options from which they award new hires or other worthy employees. This pool is limited so as to not overly dilute the ownership of existing shareholders, since every option you exercise must be backed by a newly issued stock.

ISO versus NSO
All of the discussion has been about incentive stock options (ISOs). There is also another type of option called a non-qualified stock options (NSOs) which have fewer tax benefits to the option holder. I don’t discuss them because I have never held any NSOs.

Note: These numbers are made up. I am not hinting at any of the details of my employment contract. Also check out the Fairmark guide and the Kiplinger (Intuit) guide for more information.