For example, a company might grant a new employee shares of stock vested over two years. This means that the employee will retain the stock only after two years of working there. If he leaves prior to vesting, he loses his stock in the company. This can be a powerful motivator in employee retention. Stock options can bring greater value to the employee. Stock options are also more flexible, because, unlike grants, they frequently have an early exercise option, so an employee intending to leave the company can exercise his options before the end of the vesting period and garner some of the benefit without having to stay at the company.
What You Need to Know About Stock Options
Stock grants have the benefit of being equitable property; that is, they have some intrinsic value. During times of stock market volatility, stock options can be valued less than the employee cost, making them worthless. Stock grants always retain at least some value because the employee did not purchase them outright. Additionally, some employees are not aware that they must take action to receive stock using a stock options, and they fail to exercise their options as a result. Stock grants remove that mishap by granting the stock to the employee outright. Your manager may well agree that is is fair for someone who has added a lot of value to the company to own stock even if they leave earlier than expected, especially for something like a family emergency.
The Pay-to-Performance Link
These kinds of vesting accelerations are entirely discretionary, however, unless you negotiated for special acceleration in an employment agreement. Such special acceleration rights are typically reserved for executives who negotiate their employment offers heavily. Acceleration when a company is sold called change of control terms is common for founders and not so common for employees. Companies may impose additional restrictions on stock that is vested.
And it can happen that companies reserve the right to repurchase vested shares in certain events. Options are only exercisable for a fixed period of time, until they expire, typically seven to ten years as long as the person is working for the company.
But this window is not always open. Options can expire after you quit working for the company. Often, the expiration is 90 days after termination of service, making the options effectively worthless if you cannot exercise before that point.
Compensation: Incentive Plans: Stock Options
In fact, you can find out when you are granted the options, or better yet, before you sign an offer letter. Recently since around a few companies are finding ways to keep the exercise window open for years after leaving a company, promoting this practice as fairer to employees. Whether to have extended exercise windows has been debated at significant length. Key considerations include:.
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Everyone agrees that employees holding stock options with an expiring window often have to make a painful choice if they wish to leave: Pay for a substantial tax bill perhaps five to seven figures on top of the cost to exercise possibly looking for secondary liquidity or a loan or walk away from the options. On the other side, a few companies and investors stand by the existing system, arguing that it is better to incentivize people not to leave a company, or that long windows effectively transfer wealth from employees who commit long-term to those who leave.
It is possible for companies to extend the exercise window by changing the nature of the options converting them from ISOs to NSOs and many companies now choose to do just that. Another path is to split the difference and give extended windows only to longer-term employees. With the risks of short exercise windows for employees becoming more widely known, longer exercise windows are gradually becoming more prevalent.
As an employee or a founder, it is fairer and wiser to understand and negotiate these things up front, and avoid unfortunate surprises. The FAST templates give some typical guidelines about this. Confusingly, lawyers and the IRS use several names for these two kinds of stock options, including statutory stock options and non-statutory stock options or NSOs , respectively.
ISOs are common for employees because they have the possibility of being more favorable from a tax point of view than NSOs. But ISOs have a number of limitations and conditions and can also create difficult tax consequences. The option holder becomes a stockholder sooner, after which the vesting applies to actual stock rather than options. This will have tax implications. While stock options are the most common form of equity compensation in smaller private companies , RSUs have become the most common type of equity award for public and large private companies. Facebook pioneered the use of RSUs as a private company to allow it to avoid having to register as a public company earlier.
Each unit represents one share of stock or the cash value of one share of stock that the employee will receive in the future. RSUs are difficult in a startup or early stage company because when the RSUs vest, the value of the shares might be significant, and taxes will be owed on the receipt of the shares.
But for cash-strapped private startups, neither of these are possibilities. Fidelity Investments. Accessed Feb. Internal Revenue Service. Financial Industry Regulatory Authority. Full Bio Follow Linkedin. Follow Twitter. Read The Balance's editorial policies.
How Do Employee Stock Options Work?
Reviewed by. Roger Wohlner is a financial advisor and writer with 20 years of experience in the industry. He specializes in financial planning, investing, and retirement.