Job Offer - Explain Stock Options [US]

Question

I just got a job offer that I intend to accept, and part of the benefits explanation says,

Pending formal approval of the [Company Name Redacted] Board of Directors’ compensation committee, your offer includes [Number Redacted] employee options. Upon Board approval, you will receive a Stock Option Agreement that will provide all of the detailed terms of your option grants.

I understand this means that nothing is guranteed, but when the Board of Directors meets I can be granted a set number of employee stock options. However, I do not understand exactly what that means. Do I have to buy the stocks outright when I start my job?

Say I have 100 options, and the current value is $10. Am I essentially "gifted" 100 shares of stock, or just given the opportunity to purchase the shares?

This is a private company, venture capitalist backed if that makes a difference.

Answer 1

An option is a financial instrument instrument that gives you the right, but not the obligation, to do some transaction in the future at a given price. An employee stock option is a kind of "call option" -- it gives you the right, but not the obligation, to buy the stock at a certain price (the "exercise price", usually set as the price of the stock when the option was granted). The idea is that you would "exercise" the option (buy the stock at the given price as provided by the option), if the value of the stock is higher than the exercise price, and not if it is lower.

The option is gifted to you. But that does not mean you get any stock. If and when you choose to exercise the option, you would buy the stock with your own money.

At what time you can exercise the option (and how many shares you can exercise at a given time) will be specified in the agreement. Usually, you can only exercise a particular share after it has "vested" (according to some vesting schedule), and you lose the ability to exercise after you no longer work for the company (plus perhaps a grace period), or after the option expires.

Answer 2

Its important that you carefully read the agreement, if you accept the job. The options agreement will usually specify the vesting schedule, the strike price, and the number of options you will have.

When you start vesting options, you can choose to buy stock at the strike price. When you do exercise the options, your employer will likely withhold state and federal income tax. The strike price will hopefully be well below the market price.

Unlike stock, when your employment ends, you usually are not able to hold on to your options. There's typically a small window of time in which you can exercise your options. You should read this part of the agreement carefully and plan accordingly.

Answer 3

There are a few other items that you should be aware of when getting options:

• The strike price is usually determined by an independent valuation of the common shares (called a 409a valuation). This should give you a sense on what the options are worth. Obviously you are hoping that the value becomes many multiple of that.

• There are two kinds in the US: Non-quals (NQO) and Incentive Stock Options (ISOs). The big difference is that when you exercise Non-quals, you have to pay the tax on the difference between the "fair" market value on the shares and what you paid for them (the strike price). This is important because if the company is private, you likely can not sell any shares until it is public. With ISOs, you don't pay any tax (except AMT tax) on the gain until you actually sell the shares. You should know what kind your getting.

• Some plans allow for early exercise, essentially allowing you to buy the shares early (and given back if you leave before they vest) which helps you establish capital gains treatment earlier as well as avoid AMT if you have ISOs. This is really complicated direction and you would want to talk to a tax professional.

And always a good idea to know how many total shares outstanding in the Company. Very few people ask this question but it is helpful for you to understand the overall value of the options.

Answer 4

Since the 2 existing answers addressed the question as asked. Let me offer a warning. You have 10,000 options at $1. You've worked four years and the options are vested. The stock is worth $101 when you get a job offer (at another company) which you accept. So you put up $10k and buy the shares. At this moment, you put up $10K for stock worth $1.01M, a $1M profit and ordinary income.

You got out of the company just in time. For whatever reason, the stock drops to $21 and at tax time you realize the $1M gain was ordinary income, but now the $800k loss is a capital loss, limited to $3000/yr above capital gains. In other words you have $210k worth of stock but a tax bill on $1M.

This is not a contrived story, but a common one from the dotcon bubble. It's a warning that 'buy and hold' has the potential to blow up in your face, even if the shares you buy retain some value.