What Are Stock Options and How Do They Work for Employees?

You’re likely to be offered stock options at some point in your tech career. Here’s what you need to know.

Written by Lisa Bertagnoli
What Are Stock Options and How Do They Work for Employees?
Image: Shutterstock
UPDATED BY
Matthew Urwin | Sep 22, 2023

Stock options are an opportunity for employees to receive a future equity stake in a company by getting the option to purchase its stock at a set price. That stake in the company often motivates employees to work hard to help the company succeed and stay with the company longer.

Stock Options Definition

Stock options are a form of compensation where employees have the right to purchase a certain amount of the company’s shares for a set — and often discounted — price. Because stock options aren’t available right away and typically become available in broken-up amounts over time, employees are incentivized to stay longer with their employer.

Shariq Siddiqui loves stock options. As co-founder and CEO of contactless shopping startup Veeve, stock options help him entice talent to his company and ensure they stay for a few years.

He’s not yet able to offer hundreds of thousands of dollars in salary to seasoned engineers, but he can offer new Veeve employees the chance to work hard to make Veeve a success, then cash in on that success.

“Equity is the currency you use to negotiate,” Siddiqui said. “It’s a competitive equity structure so the people working for you are completely vested and have the same goals as you do.”

The tech industry didn’t invent stock options. But it did make them popular as a recruiting and retention tool in the early days of the internet, said Dan Sachs, executive director of education and programs at the University of Chicago’s Polsky Center for Entrepreneurship and Innovation. Startups big on ideas but short on cash offered hefty stock option packages in lieu of hefty salaries, the idea being that as the company grew, its value — and the value of the stock options — would grow too.

 

How Do Stock Options Work?

If stock options are part of your company’s compensation package, you’ll get them most likely three or six months after your start date. You’ll be asked to sign a legal document and set up an account at the company your employer uses for equity management.

For example, at Veeve, most of the 30 full-time employees have stock options. Veeve hires college graduates as interns for six to nine months, then conducts a performance review. Those hired as full-time employees receive a full compensation package of salary, stock options and a retirement savings plan.

Generally, you can’t exercise the options — meaning buy the stock — right away. The stock becomes yours to buy over time, which is called vesting. The longer you stay with the company, the more you are vested in the stock, meaning you have the option to buy a greater portion of the shares. The tech-industry standard is a four-year vesting period with a mechanism called a cliff. After a year, you’ll be 25 percent vested in your options, and then shares available to you to exercise pile up on a monthly basis.

“It’s an opportunity for an employee to receive a future equity stake in a company through an option to purchase stock at a predetermined set price,” Sachs said. Offering that equity stake, or chance to literally own a piece of the company, motivates employees to work hard to make the company successful, and stay with the company so they can see their stock options turn into actual stock ownership.

Say your employer is already publicly traded, and you receive stock options. You’ll have the option to purchase a set number of shares at the strike price within a specific period. At the end of the vesting period, you’ll be able to purchase stock at the strike price, assuming that the stock’s fair-market price is not below the strike price, said Dylan O’Shea, a Merrill Lynch financial adviser based in New York City.

O’Shea adds that stock options can create “windfalls” that help people accomplish their financial goals. “We encourage developing a plan to assign the eventual sale proceeds to a specific goal, such as home renovations or purchase, saving for college or investing for retirement,” he said.

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What Is a Strike Price?

Stock options come with a strike price (also called the grant price), which is the price at which you will buy your share. Because strike prices can change as a company grows, your options might have a different strike price than a colleague who started at the company two years before you or two years after you.

A Stock Options Glossary

  • Stock option: A chance to buy equity in your company at a later date. 
  • Non-qualified stock option (NSO): Typically the type granted to full-time employees; they are taxed differently than incentive stock options. 
  • Incentive stock option (ISO): The kind usually granted to vendors or outside consultants; they are subject to capital-gains taxes, while NSOs are not. 
  • Option pool: The amount of stock your company’s founders set aside to use as incentives for employees. 
  • Strike price: The price per share you are offered when you receive options; this is the price at which you will purchase them in the future. 
  • Vesting: The process of, over time, making you eligible to exercise your stock options; in other words, purchase them. 
  • Exercise: The act of purchasing your stock options; after the purchase, you actually own stock in the company. 
  • Trigger: An event, say your company is acquired, that can automatically vest you in all of your options.

Which brings up a question. Who decides how much your company is worth? Companies hire independent appraisers to set a value for the company, much like houses are appraised, said Neil Tiwari, who previously worked in business development at Pulley, a startup that manages equity plans for companies. The company is reappraised every so often as it matures and grows.

In its early stages, your company’s founders decide they will set aside a certain percentage of the stock (10 to 25 percent is customary) for employees. If a company grows quickly and that pool empties, the board can increase the size of the pool. However, “the consequence is that everyone else’s stock is diluted,” Tiwari said.

 

When Should You Exercise Stock Options?

Let’s say an employee has 500 shares, 25 percent of which are vested and available to exercise after one year of employment. This employee plans to stay at the company for the foreseeable future.

The benefit of not exercising the options until all are fully vested is the employee will likely pay less taxes and receive more money, as the price of stock typically rises as time goes on, said Marlo Richardson, founder of Business Bullish, a website and resource that trains people in financial literacy and entrepreneurship.

“Outside of a dire emergency, I would recommend letting the stock become fully vested and then exercise the options when they are well above the strike price,” she said. “In a perfect scenario, roll the income into a qualified annuity and save more on the taxes.”

The employee described above might well wait for a triggering event — an acquisition or public stock offering that automatically vests all the options. “The benefit of not exercising at all is that the stock has the ability to increase in value and since it was a gift, at some point there is 100 percent gain as the result of any triggering event,” Richardson said.

On the flip side, “the drawback of not taking your money when it’s available is that you never know what’s going to happen that could trigger a market crash,” Richardson said. When events such as the 2008 market crash and the pandemic upend the market, “companies usually suffer, which means stocks as well,” she said.

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How Do You Get the Most out of Stock Options?

Your gamble, as an employee, is that the company’s value per share will be greater than the strike price. Say you’re offered 500 shares at a strike price of $5 per share. If the company is worth $20 a share when you exercise the options, you’re getting the stock at a 75 percent discount. If you sell the stock back to the company, or your company goes public or is acquired, you stand the chance to make money (taxes and capital gains must be accounted for) if the sell price or merger price per share is higher than that $5 strike price.

The hope is that the company you work for is acquired by a bigger organization in a cash or stock deal. Most of the time, your company’s equity plan includes a trigger, which is a financial event that would automatically vest you in all your shares, no matter where you are on the vesting timetable. For example, if your strike price is $5 a share and your company is acquired for $20 a share, you will realize $15 a share after taxes and capital gains, which will be different depending on your financial situation. (On the flip side, you can lose money if the price per share dips below your strike price.)

Absent a triggering event, you can buy shares as you become vested in them, or wait until you’re fully vested and purchase all of them at once. (Each approach has tax implications, so consult your accountant or financial adviser.)

You can also choose to not buy them. The caveat: Once you leave a company, you generally have 90 days to exercise your stock options (unless a longer period is part of a severance negotiation). After that, your options expire and you no longer have the chance to buy them.

If you do buy your options before leaving the company, you can hang on to them as you would any other investment.

 

What Are the Different Types of Stock Options?

Companies typically grant two types of stock options: incentive stock options and non-qualified stock options. But employees may also earn compensation from other equity incentives. 

 

Incentive Stock Options (ISOs)

Incentive stock options allow leaders and full-time employees to purchase stock in a company at a discounted price. ISOs also receive slightly more favorable tax treatment, Tiwari said. With ISO options, employees pay tax only when they sell the shares they have purchased. As a result, this type of stock works best if an employee plans to buy and hold onto their stock for a while before choosing to sell it. 

 

Nonqualified Stock Options (NSOs)

NSOs are often for contractors, advisers or other outsiders (meaning not employees) “looking for more skin in the game,” said Siddiqui of Veeve. The catch is that those who receive nonqualified stock options must pay taxes on the difference between the grant price and the price they paid when exercising the stock. The price of these stocks is also similar to their market value, meaning workers don’t get as much of a discount when purchasing NSOs.   

 

Restricted Stock Units (RSUs)

Restricted stock units are compensation that vest over a period of time (a year is standard) or when certain job milestones are achieved. While RSUs have no initial value, they are much more likely than stocks to have value once they vest. Employees also become owners of RSUs as soon as they’re vested, compared to only being owners of stock options once they exercise them.  

Here’s an example of how RSUs can work: Michael Vilardo is co-founder and COO at Emile, an edtech startup now known as Subject that’s focused on premium on-demand courses for high-school students. Previously, Vilardo had been the fifth full-time employee at Dispatcher, a transportation and trucking company. Uber acquired Dispatcher in 2016 to help launch Uber Freight. Along with Dispatcher, Vilardo and his colleagues were “acqui-hired,” meaning Uber retained them and their expertise post-acquisition. Their compensation package included equity in Uber, which was then a privately held company.

On May 10, 2019, Vilardo’s restricted stock was recognized as income at Uber’s $45-per-share debut price. The resulting money, plus a full scholarship to earn an MBA, gave Vilardo the means to launch Emile. “Without those two, I would not be a full-time entrepreneur,” he said.

To pay it forward, literally and figuratively, Vilardo and his co-founders in Emile offered stock options to their employees. “We want people to buy into our vision,” he said. “Everyone has incentives for the company to do well.”

 

Restricted Stock Awards (RSAs)

Restricted stock awards are compensation that an employee becomes a legal owner of on the day they are granted. However, RSAs often come with a vesting period and can’t be freely traded until a length of time has passed or job milestones are completed. While this limits employees’ ownership stake in a company, it also saves them from paying hefty taxes. Employees aren’t taxed on RSAs until they vest, and the amount taxed is the difference between the market value of the RSA when it vested and the purchase amount. 

 

Employee Stock Purchase Plans (ESPPs)

Employee stock purchase plans enable employees to purchase company stock at a discounted price through a company-run program. When offered a chance to participate, employees can opt in by having a certain amount taken out of their paycheck. This amount builds up over time, and a company uses these funds to purchase some of its stock on the employee’s behalf.

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Why Would Someone Turn Down Stock Options?

Stock options seem like a win-win: Founders can use them to woo high-level employees while retaining the cash crucial to sustaining a startup. Employees gain early entry to a company that might be wildly successful, and the chance to learn more and do more than they would at a bigger, more established company, Siddiqui said.

So when would anyone ever turn down stock options? Here are a few reasons. 

 

Uncertain Company Outlook

An employee may simply be marking time at a company and have no faith in its ability to grow or isn’t sure how long they’ll stay at the company.

“Stock options are sexy, but cash is cash,” said Dan Sachs of the Polsky Center. “If you don’t know where you’ll be three years from now, and you don’t want to be handcuffed to the company, then getting cash is a much better deal for you,” he said. Employees in that situation might negotiate for a higher salary in lieu of stock options.

 

Tax Expenses

Even if stock options become available at an attractive price, workers need to be careful about tax implications later down the line. If an employee is making just enough to get by and has to worry about paying taxes on exercising stock options, they may want to hold off on purchasing stock until they’re on more stable financial ground. 

 

Extensive Restrictions 

An organization may offer stock options or equity compensation with many strings attached. For example, stock may come with the requirement that an employee needs to meet certain performance milestones during their time with the company. Employees may want to consider whether they can meet any time-related or performance demands before deciding to move forward with exercising stock options. 

 

Additional Considerations

O’Shea of Merrill Lynch also suggested finance-related questions owners of stock options should ask themselves:

  • What happens to your options if you leave the company or it’s acquired?
  • Have you added your company’s blackout and trading rules into your personal cash flow calendar so you don’t need to make a poorly-timed financial decision to cover until the next window opens?
  • Have you discounted the value of the stock option by either the strike price or taxes? Or did you overbudget and set yourself up for an unfortunate surprise?
  • Do your options represent more than 10 percent of your net worth? If so, a major fall in share price could seriously and negatively affect your financial picture.

If you do accept stock options, then congratulations — and our fingers are crossed that your company is tech’s next newsmaker, ready to go public with a splash.

 

Frequently Asked Questions

A stock option gives an employee the right to purchase a specific number of company shares after they’ve been with their employer for a certain period. These shares become available in set amounts over time and can often be purchased at a fixed and discounted price — referred to as the strike price, grant price or exercise price. 

If a company’s value per share is higher than the strike price at which an employee purchases a stock option, then an employee can make money from their stock purchase. Employees may also make money by selling the stock back to their company or if the company goes public or is acquired by another organization.

It depends on the situation and an individual’s circumstances. Employees may want to consider stock expenses, their company’s outlook and their professional goals at their company before deciding to purchase stock options.

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