Equity Series, 3: Stock Options from Employees' Perspective - Preferred CFO

As a means of attracting top talent, management will often grant stock options as additional compensation. It is also a great way to align the interests of management with employees. As everyone works together to improve the company, the value of the stock price increases and employees benefit from the pop. Since options are becoming more popular, it is important to understand how they work. This article addresses stock options from the employee’s perspective.

Two basic kinds of options exist; qualified (QSO) and non-qualified (NQSO). There are several differences between the two including how they are taxed and to whom they may be granted.

• QSO’s are tax-free if you are in the lower two tax brackets, or taxed as capital gains (15%) if you are in the higher tax bracket, which is lower than ordinary income. NQSO’s, on the other hand, are taxed as ordinary income. This makes QSO’s much more attractive, but they come with more restrictions.
• QSO’s can only be issued to employees, and NQSO’s can be issued to anyone.
• QSO’s cannot be exercised until one year after the grant date and they must be held for one year after exercised before being sold, but non-qualified have no restrictions for the holding period. If QSO’s are sold before the one year mark, they are treated like NQSO’s.
• The total fair market value of QSO’s exercisable for the first time cannot exceed $100,000 in a calendar year. NQSO’s have no limit to their value.

The restrictions applied to qualified stock options are a result of concerns that insiders will manipulate the stock price to gain more from their options. Because they have favorable tax treatment, they are monitored closely.

What This Means for You

Because companies issue stock options to employees as an incentive, they are usually free which means there is no downside—other than you, as a marketable employee, may be foregoing a higher salary elsewhere for the options. Nevertheless, if the market price is higher than the exercise price, then you pocket the difference without having to pay anything.

However, consider the following scenario: You have the option to go to several different companies who all offer you comparable compensation. You believe that one of these companies will outperform the others and has more potential. But typically it is a smaller company and you may have been offered a lower salary. So you have to not only weight the potential risk that the smaller company may shrink and close up shop, but also the risk that the value of the company may not increase in value significantly enough to outweigh the loss from salary you would have received. Furthermore, options are only worth something if someone else is able and willing to buy it from you. Either the company needs to be sold to a larger acquirer, go public, or your quantity of shares must be large enough that there is sufficient interest to venture capitalists interested in buying “secondaries.” Secondaries are shares they are purchasing in a company from employees or other management members rather than from the company as part of a raise of funds.

Options can get confusing, but if you stick to the basics (and consult a tax professional) they can be a great way to come out ahead.