Disclaimers: I am not an attorney, I am not a tax professional, I am not in any way officially qualified to give advice on financial matters of any kind. I am simply an employee of a company that provides some compensation in the form of ISO stock options, and I’ve done some research to better understand how stock options work and how they may eventually be of value to me. My intent here is simply to share some of what I’ve learned. Please be advised that I could be wrong, or could have left something important out. I hope that others will do their own research, and seek out help from people more qualified than I am, in order to make a plan that works best for them. I am also focusing here primarily on Incentive Stock Options (ISOs) as that is what is what is given out at my company, and most commonly given to employees at early stage startups.
What are stock options?
First, let’s clarify what stock options are not. Stock options are not stock. If you’ve vested options in your company, you may believe that you now own shares in that company, but that is not the case. Unlike stock, stock options do not follow. If you decide to leave the company, and you do not exercise your stock options, you lose your right to those options, and they get reabsorbed by the company.
Stock options, rather than stock itself, are the right to purchase stock in the company, at a predetermined price. This predetermined price is called the strike price.
What is the strike price or exercise price?
The strike price, sometimes called the exercise price, is the cost to you as the owner of the stock option to purchase the stock. The stock option agreement essentially states that you can purchase the stock at this price, regardless of the current market price for the stock. Obviously, the idea is that the strike price is ultimately less than the market price of the stock, allowing you to buy the stock at one price, and sell it at another, making the difference as income for yourself.
This can trip people up. If you are vested in options at your company, and the strike price is $1.00 per share, and the current market value of the shares is $3.00, then if you exercised your options and then sold your shares, you’re only making $2.00 per share, not $3.00 per share, since you had to fork over $1.00 per share for the exercise.
What is vesting?
Vesting is basically just a fancy term for deferring the actual ownership of the stock options over time. When companies issue stock options, they usually grant the options all at once, but the employee doesn’t take ownership right away. Instead, the options transfer to the employee over time, or sometimes when certain milestones are hit.
You cannot exercise stock options that you have not yet vested.
The most common example I’ve seen is a 4 year vest period with a 1 year cliff. What this means is that if you are given 1,000 shares, you earn nothing for the first year, but at the end of the first year you take ownership of ¼ of the options. Each month after that for the next 3 years you receive 1/48th of the options, at which point you have fully vested your options.
What is the expiration date?
The expiration date is the last date before which you can exercise your options. If you do not exercise your options before this date, you lose the right to exercise them, and the options get reabsorbed by the company that issued them.
Usually the expiration date is years after the stock is granted – often 7 or 10 years.
What is Fair Market Value?
The fair market value of shares of a public company is determined by the market. People can buy and sell shares at will, and this leads to a price that the market deems fair at any given time.
Private companies do not have a market for their shares. Instead, they have to go through a process called a 409a valuation to determine what their shares are currently worth. This process is done at least annually, and sometimes more than once in a year if for example the company raises money during that year.
The fair market value can give you some sense of what your shares are worth, but…not really. The process is only done once a year, and it’s a fairly abstract process. A share is really only worth what someone is willing to pay for it, assuming that you’re willing and able to sell it. So determining the value of a share outside the context of a transaction involving shares is somewhat silly.
In practice, the fair market value is mostly used for tax purposes (see the sections on the AMT tax below). Companies issuing stock options also have to set the strike price equal to the current fair market value.
What happens if I leave the company before exercising?
Your company sets the terms and conditions for what happens when you leave, but generally upon the last day of employment at the company, you have 90 days to exercise your options. Any options not exercised after that 90 days is up will be reabsorbed by the company, and you lose the right to exercise them.
Some companies have given their employees the right to exercise their options for longer than 90 days after they leave. However, if you were given ISO options, by law, after 90 days of leaving the company, ISO options automatically convert to Non-qualifying Stock Options (NSOs) which are much worse for employees from a tax perspective.