Stock options are used by many tech companies from start-ups to stable enterprises, but often in really different ways. Here at FPC, our goal is to help you discover your wealth’s full potential, and understanding your stock options is a big part of that. We hear questions about stock options all the time, and so we decided to do something exciting here at the start of 2020.
We’re putting together a series of articles that take a deep-dive into different types of stock options:
- Restricted Stock Units (RSU)
- Non-qualified Stock Options (NQSO)
- Incentive Stock Options (ISO)
- Employee Stock Purchase Plans (ESPPs)
Each article will explain what the difference is between each of these stock options, and how they could potentially impact your financial plan. Before we dive in, we wanted to answer a few high-level questions about stock options as a whole to kick off this education-focused series. Ready? Let’s dive in.
Defining Terms
Many people find stock options unapproachable. The jargon you hear when it comes to stock options makes them seem complicated. However, the truth is that when you understand what terms are being used, and how your options work, you’ll be able to make empowered decisions about your employee stock options in the broader context of your investment strategy.
Let’s look at a few key definitions to get started:
| Term | Definition |
| Grant Price | The price at which your company will allow you to buy the stock. |
| Fair Market Value | How much the stock is worth on the market. |
| Number of Shares | How many shares your company provided in your employment contract. |
| Vesting Schedule | The time-frame for when and how your options vest. Some companies may have all of your options vests at one time (cliff vesting), but there may be additional provisions that release certain options at a time (graded vesting). For example, if you have 100 shares, 50 shares will be vested in 1 year and the remaining after 2 years. |
| Exercise Date | The date you exercise your options. |
| Expiration Date | The date by which you exercise your options, or they will expire. |
| The Spread | The difference between the grant price and the fair market value. |
What are employee stock options, and how do they work?
Before we can get into the nitty-gritty of what different types of stock options look like, we need to start with the basics: How Do Employee Stock Options Work?
Stock options are considered equity compensation. In other words, instead of granting company stock directly to their employees, employers offer “options” on the stock. These are standard call options, which give employees the flexibility to buy company stock for a set price over a predetermined period of time.
Typically, companies set up a stock option plan that is based on a predetermined timeframe. For example, your stock options might not be fully vested until you’ve been with the company for four or more years.
More often than not, your stock will vest a little bit at a time over several years. This incentivizes you to stick around and to continue doing a phenomenal job for your employer because there will (ideally) be a payout at the end of your vesting schedule.
When your stock options vest, you can sell or trade them within your trading window. Your trading window will be a limited period of time during which you can sell or trade company stock. Trading windows help to protect both you and your employer against insider trading.
Additionally, your trading window can make creating a plan for your fully-vested stock options more streamlined. Without an endless window to decide what to do with your options, you’re more likely to put a plan in place that serves your goals.
Ideally, your employer’s stock will have grown in value beyond the original option you have available. When your options vest, you’re able to take advantage of this growth and sell them for a potential profit.
Of course, as with all things in the world of investing, you need to do careful planning around when you sell your employee stock options. This is important so that you can maintain a diverse portfolio, and ensure your sale is as tax-efficient as possible.
Remember: Your stock options will be different from others. How you understand, think about, and use your options may be different from a co-worker or a peer at another company and that is ok. Don’t compare your strategy with someone else’s!
What’s Next?
Many employers in the tech sector use employee stock options as part of their compensation, which is why it’s so important to be familiar with the different types of stock options you might encounter. The more you’re able to arm yourself with knowledge, the more quickly you can start to leverage your employee stock options to reach your short and long term financial goals.
Our next installment of the stock options series will be the first where we truly dig into one of the specific types of employee stock options available: RSUs. Stay tuned!