By David Gardner, CFP - Yellowstone Financial
Employee stock options first came into the public eye in late 90s. Newly minted B-school graduates would compare compensation packages. They wouldn’t focus much on salary and bonuses, but more on “the options.” After all, to get wealthy through a paycheck takes decades of spending less than you earn. But with options this could be achieved in a year or two of frenzied work leading to an IPO – an initial public stock offering.
Today employee stock options don’t provoke the same heart pounding exhilaration as the 90s. Many of those paper millionaires who worked for dotcoms such as Pets.com and Webvan saw their seven figure net worths crash into oblivion by the time 2000 came around. But stock options still have their place and can be a valuable part of your compensation package at established and emerging companies. While this topic can be very complex, we’ll touch upon the major points so you can understand your options or at least follow what your friend or family member is talking about when they say “I got some more options.”
What are stock options? While there are many types of options, employee stocks options generally give the employee the right to purchase shares of stock of the employer at a certain price. The company can be privately held such as Boulder-based Orbotix or Sendgrid or publicly traded such as Ball Corporation in Broomfield. They are called options because the employee has the right to purchase stock at a certain price for a number of years. If your pre-IPO company does well, you may have options to purchase company shares for 25 cents, which means you have a nice potential profit at an IPO price of $18. Most options have vesting schedules, which means you don’t get all of your granted options at once but over a number of years to help encourage your long-term commitment to the company.
How much are stock options worth? Options have two fundamental components of value. The first portion is the discount the option holder receives on purchasing a share of stock. If you have 10,000 options to purchase your company’s stock at $1 a share which currently trades at $20 a share, then the discount is worth $19 a share or $190,000. The second source of an option’s value is the ability to capture the future appreciation of a stock without spending a penny to do it. Consider that the 10,000 options don’t expire until 2023. There is tremendous value in the ability over nine years to participate in the potential increase in that stock’s value. For more information on this elusive component, research the term Black-Scholes.
Are there different types of stock options? Most common are nonqualified stock options (NSOs). When you purchase shares using NSOs, you need to pay tax on the bargain you’re getting just like any other income you receive as an employee. In the example above, that would mean your employer would report $190,000 in additional compensation to your salary and bonus upon exercise of those options. This shows up on your W-2 at the end of the year. More complex are incentive stock options (ISOs), which often are issued by pre-IPO companies. These are like financial uranium, powerful if used carefully and wisely but they can crush your finances if you’re not careful. ISOs give you the ability to purchase shares without paying payroll or ordinary income taxes but you may owe Alternative Minimum Tax also known as the AMT. If you have significant ISO options, unless you have a penchant for wading through tax code it makes sense to hire an expert to navigate through the tax and investment considerations.
Final point to consider. When you’re in the midst of building a startup, your first response toward your company’s prospects will usually be strong optimism. Don’t let this positivity blind you to the fact that if you have the opportunity to exercise and sell shares that would change your financial situation significantly, it should be weighed carefully. It’s not disloyal to exercise and sell a portion of your shares. Many times it can form the critical foundation to building future wealth.