How to Exercise Stock Options
As stock options gain more ground as part of the employee compensation package, questions about how this tool works are becoming more common.
Stock option, as the name suggests, is the option given by the company to the employees to own a part i.e. to buy stocks of the company at a predetermined price. Why would one buy stock of the company he or she’s working for? Well, due to the fact that these options are offered at a price which is significantly lower than the market price and hence, it is a profitable proposition for the employee, if he or she chooses to sell.
Now, suppose the market price of the share of a company is USD 10, the company will, for good performance and as part of the compensation package, offer the employee an opportunity to buy (exercise) the stock of the company, at a price which is less than the market price. This is known as the grant price. Let us assume that this is USD 5. Now, if an employee decides to buy 100 shares at the grant price and sell them off immediately at the market price, he or she has the chance to earn a pretty penny. The expense will be USD 500 (USD 5 x 100 shares) while the income from the sale of shares will be USD 1000 (USD 10 x 100 shares), so in this transaction, one can pocket USD 500 upfront! And if the share price is expected to go up after a year to say USD 20, he or she can sell the shares at USD 2000 (USD 20 x 100 shares) and gain a higher profit.
Let us look at the terms involved in this process:
- Grant Price: The grant price is the price at which the shares are sold to the employees of the company. This price, when fixed, is supposed to be less than the market price. So if the employee buys the shares at a time when the grant price is less than the market price, then he or she has a chance of making a profit on an immediate sale, as outlined in the above example.
- Vesting Period: It is the period an employee needs to be employed with a company, before he or she can choose to purchase a stock option. Companies may grant the options all at once or over a period of time. The options may require the employee to meet certain performance goals before it can be exercised.
- When to Exercise Stock Options: Ideally, one ought to buy the stock when the difference between the grant price and the market price is at its highest, the market price being the higher one. This way the employee ends up buying the stock a lot cheaper and has a chance of gaining more profit. On the other hand, financial difficulty may also force your hand in exercising this option, irrespective of the market conditions.
Well, that really depends on the type of stock options on offer. The first type is the Incentive Stock Option (ISO). An ISO will not be taxable, but gains (if any) from the sale of these shares will be charged on the long term capital gains tax rate. The other type is of the Non Qualified Stock Option (NQSO), which is taxable on the saving (market price – grant price). The income tax rate depends on the tax bracket the employee falls under as defined by the IRS. Also, the long term capital gains tax would be applicable, as specified above, on the sale of stock.
Of course, the rules for tax deduction differ from country to country and are subject to change, so it is always good to check with a qualified tax adviser, who can review your individual case and guide you accordingly.
The stock option has become an important tool to reward and retain select employees based on their performance and loyalty towards the company.