Employee Stock Options: What They Are, How They Work

Employee stock options are a common form of equity compensation that give employees the option to buy a certain amount of company stock at a pre-set price^[0]

Many employers offer stock options as a way to align employee interests with company interests and to attract and retain talent. They can be a meaningful component of a job offer or promotion compensation package, so it’s important to understand and evaluate how their current and potential value fit with your financial goals.

Employee stock options have five key stages. Here’s what to know about each.

1. The grant date is the date on which your employer awards you the stock options. At this point, you’ll get information about the number of shares you will have the right (but not the obligation) to buy, the strike price, when the options vest and when they expire. 

2. The vesting period is a waiting period between the grant date and when you’re allowed to exercise the options. It may be months or years long. Your company might allow you to exercise employee stock options early (before they vest). This is sometimes referred to as an 83(b) election, and it can have some tax advantages. If you leave the company before your options have vested, you may forfeit the right to exercise them. 

3. The exercise date is the date on which you purchase company shares. It usually makes the most sense to exercise stock options when the strike price is below the fair market value of the company’s stock, but there are other considerations as well. Depending on the type of stock options you have, you may owe taxes when you exercise your options. 

4. The sale date is the date on which you sell the shares you acquired by exercising your options. Selling your shares for more than you paid for them may create a taxable event. More on that below.

5. The expiration date is the date on which your options expire, meaning they’re no longer exerciseable. Options typically expire up to 10 years after the grant date.

Employee stock options can be complicated, and it takes effort to navigate them strategically. If you’re not comfortable doing it on your own — or even if you are — it may be worthwhile to consult with a financial advisor who understands equity compensation and can help you evaluate all the factors of your specific situation.

There are two main types of employee stock options.

How your employee stock options are taxed depends on the type you have.

• NSOs can be taxable on two occasions: First, when you exercise your options, you may have to pay tax on the discount you receive if you’re buying the shares at a below-market price. Second, you may have to pay capital gains tax on any profit you make if you later sell those shares for more than you paid for them.

• ISOs typically don’t come with a tax bill when they’re granted, when they vest or when you exercise them. Instead, taxes are typically deferred until you sell your shares. If you meet the holding-time requirements, you may pay capital gains tax rates instead of ordinary income tax rates. 

To take full advantage of the preferential tax treatment of ISOs, be aware of the holding requirement and of alternative minimum tax.

You may avoid paying ordinary income tax on the discount you received when you exercised your shares if you hold your shares for at least a year after the exercise date and for at least two years after the grant date.

Although ordinary incomes taxes are deferred when you exercise your ISOs, the discount might trigger alternative minimum tax (AMT). AMT is a tax system that runs parallel to the standard tax system but has different tax rates that are intended to ensure certain high-earning taxpayers pay at least a minimum level of income tax.

If you leave your job, the fate of your employee stock options largely depends on whether they’ve vested. Be sure to review your stock options agreement to get the specific details on what happens to your options if you retire, get fired or otherwise leave the company.

• Unvested options: You’ll probably lose any options that haven’t vested, though there are exceptions.

• Vested options: You’ll typically maintain the right to exercise stock options if those options have vested. However, you may be required to exercise those options in a timely manner, such as within 90 days of leaving the company.