Stock options can be really hard to understand. If you’ve ever gotten a job offer that grants you options and thought, “wtf??” then this article may be right up your alley. I wrote it because I didn’t understand stock options until a few years ago, and since then I’ve learned that they are too meaningful to ignore. In this post, I’ll walk through what stock options are, how they work, why you should care about them, and more.
Before we start, it’s important to note that this is a brief overview of stock options and isn’t exhaustive. It does not cover a lot of important details, like how your tax liability can change. I’m not a certified financial professional and this information is not meant as advice of any kind. If you do want advice about your stock options, you should speak with a certified financial advisor.
What are stock options?
Stock options give an employee the right, but not the obligation, to buy (and potentially sell) stock at an agreed-upon price and date.
The agreed-upon price is called a strike price.
The date you get to buy the options depends on when your options are vested. Vesting is the process of earning your stock options over time. Stock options vest on a schedule called a vesting schedule.
Vesting schedules are different depending on the company and grant, but the most common vesting schedule is four years with a one year cliff. In this vesting schedule,1/4 of your stock options vest after one year at the company. Nothing is vested before hitting one year. After you pass the one year cliff, 1/48 of the original grant continues to vest each month until the four-year vesting period is over. After four years, you are fully vested.
Exercising Stock Options
Once you’ve vested any amount of options, you have the option to exercise them. This is a fancy term for buying your stock options.
Why would I exercise my stock options?
Stock options have the chance of turning into cash – and sometimes a lot at that! This is because they may be worth more than you paid for them one day. Here’s a quick example:
Let’s say you had 1,000 stock options at a strike price of $1. It would cost you $10,000 to exercise these options because 1,000 x 1 = 1,000.
Now let’s say some years have gone by and your company is on fire…in a good way. The stock is now worth $10 a piece. Well that would be good news for you! You could sell your 10,000 options for $10,000. That’s a $9,000 profit!
It’s important to note that this example does not include tax liability.
Why would I not exercise my stock options?
There are a few reasons. First, exercising stock options can feel a lot like gambling. If you exercise stock options before you are able to sell them, there is a chance that they become worthless if the company goes under or just worth less than what you bought them for if the company goes downhill. That’s scary! Second, there is a high likelihood you’ll need to have the cash available to exercise them. If you were granted a lot of options or the strike price is high, this could be a lot of cash. For some people, this isn’t an option. Some companies combat this issue by doing something called a “cashless exercise” (see glossary at the end of this post for more details).
I decided to exercise, when should I?
It depends – and I’m not just saying that. Your financial situation, the amount of options you have, your income, and more, all factor into when it is most advantageous for you to exercise. Sometimes exercising sooner rather than later is good. Sometimes it’s not. Talk to a financial advisor and they’ll help you figure out what to do.
Selling Your Stock Options
When can I sell my stock options?
It depends on your company’s policies. At most companies, you are able to sell your vested options once your company has a liquidity event. A liquidity event is most often when a company goes through acquisition, merger, or goes public. What happens to your unvested options depends on the type of liquidity event and its terms.
One important thing to note is that some companies offer something called early exercise (see glossary) which means you don’t have to wait until one of these common liquidity events, but this isn’t particularly common.
My company had a liquidity event, should I sell my options now?
It depends! Your stock could become more valuable or less valuable depending on the company’s success. Just like trading on the stock market, or perhaps dabbling in cryptocurrency, you run the risk of either losing out on big financial gains or losing your money.
What do taxes look like when I sell my options?
It depends! There are many potential tax implications when it comes to exercising or selling stock options. In some situations, you may be taxed heavily. Don’t get caught off guard – talk to a financial advisor! Can’t say this enough!
Examples
Below are a handful of hypothetical examples. The examples get more complex as they go on. Don’t forget this simplified hypothetical scenario doesn’t include all sorts of caveats – like potential taxes, fees, etc! Like always: we recommend talking to a financial advisor if you are thinking of exercising or selling options.
Example 1: Tim 🧑🏻
- Tim is granted 10,000 stock options on their start date and their strike price is 80 cents.
- They begin vesting in accordance with Tim’s vesting schedule, which is 4 years with a 1 year cliff.
- After 4 years, Tim’s options are all vested.
- Tim talks to a certified financial professional and decides to exercise his options – it costs him $8,000 up front (10,000 options x $.80 = $8,000).
- Gatsby gets acquired by Really Big & Good Website Company and now each of his vested stock options is $10.
- Tim sells his 10,000 vested stock options for $10 each and makes 100,000. His profit is $92,000 (minus taxes)!
Example 2: Mojo 👨🏻
- Mojo granted 1,000 stock options on their start date and their strike price is 93 cents.
- They begin vesting in accordance with Mojo’s vesting schedule, which is 4 years with a 1 year cliff.
- After 2 years, Mojo decides to leave Gatsby. At this time Mojo has vested 500 stock options (50% of their 1,000 options)
- Mojo has 90 days to exercise their 500 vested options if they want to.
- Mojo talks to a certified financial professional and then decides they want to exercise, so they pay $465 (500 x $.93 = $465).
- A few years later, Gatsby has a liquidation event (an IPO in the case) and Mojo’s shares are worth $5 each
- Mojo sells their options for $2,500 (500*$5). They make a profit of $2,325.
Example 3: Joy 👩🏼
- Joy is granted 5,000 stock options on their start date and their strike price is 93 cents.
- They begin vesting in accordance with Joy’s vesting schedule, which is 4 years with a 1 year cliff.
- After 8 months, Joy decides to leave Gatsby. Unfortunately, Joy has not vested any options yet because she hasn’t passed her 1 year cliff. Joy does not get to exercise any options.
Example 4: Diamond 👩🏾
- Diamond is granted 10,000 stock options on their start date and their strike price is 89 cents.
- They begin vesting in accordance with Diamond’s vesting schedule, which is 4 years with a 1 year cliff.
- One year later, Diamond gets a big promotion and is granted another 10,000 options and their strike price is 91 cents. Go Diamond!! These options begin vesting separately, beginning the day she got promoted. They also have a 4 year vesting schedule with a 1 year cliff.
- Three years after Diamond got promoted, Gatsby gets acquired by Tesla because why not. At this point, 100% of Diamond’s first 10,000 grant has vested since it’s been 4 years since they began vesting. Also, 75% of Diamond’s second 10,000 grant has vested, because it’s been 3 years since they’ve begun vesting. That means she has vested a total of 17,500 shares (and has 2,500 shares that haven’t vested).
- Based on the terms of the sale, Diamond’s 2,500 unvested shares are canceled.
- Diamond’s 17,500 vested options are now worth $4 each. This means she could purchase the 17,500 shares for $15,725 and then sell them for $70,000. This is a profit of $54,725.
- Math for exercising: $8,900 for the 10,000 vested shares with 89 cent strike price + $6825 for the 7,500 vested shares with the 91 cent strike price = 15,725
- Math for selling: 17,500 x 4 dollars each = $70,000
- Unfortunately, Diamond is unable to take advantage of this situation because she does not currently have $15,725 on hand with which to purchase the initial 17,500 shares. Moreover, there are also taxes and brokerage fees that would add to the initial cost of exercising the options, even though it would lead to a profit in the end.
- Diamond goes and talks to her financial advisor because she isn’t sure what to do. Luckily, her employer offers a cashless exercise plan. Under this plan, Diamond is given a short-term loan by a brokerage firm of $15,725. Using this loan, she exercises her options and buys 17,500 worth of stock. She then immediately sells the shares at their market price, receiving $70,000. With this cash in hand, Emma repays the $15,725 loan from the broker, as well as any transaction and tax costs associated with the transaction.
FAQs
- Can I keep my stock options forever?
- Stock options can expire. The expiration period varies from plan to plan. Track your options’ exercise periods and expiration dates very closely because once your options expire, they are worthless.
- What happens to my stock options when I leave my company?
- It depends. If you are leaving a company and have vested stock options that you have not exercised, you may have the opportunity to do so within a defined period of time. At about 90% of companies, this period is 90 days.
- What happens to my unvested stock options if my company is acquired?
- It depends! You could get paid for them, they could turn into the new company’s stock, they could be canceled, etc. There’s a lot of possibilities.
Stock Options at Gatsby
- How do you figure out how much equity to grant?
- We use world class data from multiple sources to determine standard grant amount for each role. Check out our post on Compensation at Gatsby for more info!
- How do I understand the worth of my stock options?
- We use a dope tool called Welcome, which helps candidates and employees visualize the potential of their equity. Shout out to them for being great partners.
- How do I know how much equity I have?
- Check out Carta, which is our source of truth for all things equity. If you see something that looks weird, reach out to the People Team!
- I’m new and still confused. What do I do?
- We host a seminar on understanding your stock optins at least 1x per quarter. Be sure to attend and follow up with the People Team if you have any lingering questions!
Stock Options Glossary
Some of these terms are referenced in the article. Others are not, but are likely ones you’ll come across if you dig more into stock options.
- AMT: Aka ‘Alternative Minimum Tax’. This may be triggered depending on your financial situation when you exercise/sell options.
- Dilution: Stock dilution is when a company issues additional shares and subsequently reduces how much of the company you (and the other shareholders) own. It usually happens when a company raises money.
- Exercise: Another term for ‘buying’ your stock option(s). This occurs when the owner of an option invokes the right embedded in the option contract.
- Cashless Exercise: A cashless exercise, also known as a “same-day sale,” is a transaction in which an employee exercises their stock options by using a short-term loan provided by a brokerage firm. The proceeds from exercising the stock options are then used to repay the loan.
- Early Exercise: Another type of exercise is what’s known as an “early exercise.” Some companies’ equity plans allow this, and it just means you can exercise your options before they have vested—right after you accept the option grant, for example. Gatsby typically does not allow for early exercise.
- FMV: Fair market value of a ‘stock option’, as determined by a third party. This is often the same as the ‘strike price.’
- ISO vs NSO: An ISO is a type of stock option that can only be granted to employees and may be eligible for a US tax benefit. An NSO is a type of stock option that can be granted to any service provider (e.g., employees, directors, consultants, and advisors.)
- ISO tax benefit: ISOs sometimes have tax benefits. In order to take advantage of the ISO tax benefit, you may need to meet certain holding periods. Specifically, you must hold (keep) ISOs for at least one year after exercising and two years after your options were granted.
- Liquidity Event: A liquidity event allows company employees (and other people like investors) to convert illiquid equity into cash through events such as an IPO or direct acquisition by another company. This is often when someone would be able to sell their exercised options.
- New Hire Grant: This is the term for the stock options grant a person receives when they are initially hired.
- Refresh Grant: A refresh grant is a new additional stock option grant, given to high-performing employees later in the tenure. This often means the employee continues to be granted options after their new hire grant has finished vesting.
- Strike Price: The pre-agreed price per share at which stock may be bought or sold under the terms of an option contract. Some people refer to the strike price as the “exercise price”. It’s often, but not always, the same as the FMV.
- Vesting Schedule: The time period during which your shares vest. It is most commonly 4 years.
- Cliff: A cliff (aka ‘vesting cliff’) is when the first portion of your option grant vests. After the cliff, you usually gradually vest the remaining options. The most common cliff is 1 year.
Stock Options Resources
Financial Advisory Firms
We recommended you to talk to a financial advisor many times in this article. If you have one already, awesome! If not, there are many companies and/or certified professionals you can go to for advice. Who you talk to is up to you, but if you have no idea who to turn to, these could be a place to start!
- Charles Schwab
- Deutsche Bank
- Fidelity
- Merrill Lynch
- Morgan Stanley
- Vanguard
- Zoe Financial
🔥 Hot tip! Don’t forget to ask the financial advisor you chat with if they are a fiduciary. A fiduciary is a person that acts on behalf of another person, putting their clients’ interest ahead of their own, with a duty to preserve good faith and trust. Not all financial advisers are fiduciaries, so it’s important to ask!
Books
- Stock Options for Dummies (except it’s really for everyone!!!)
- Founders Pocket Guide: Stock Options & Equity Compensation (particularly pages 57-81)
Articles
- Carta’s Equity Series
- Smart asset: How Do Stock Options Work?
- Harvard Business Review: How Venture Capital Works
About the Author
I’m Maddie, VP of Operations at Gatsby. I currently curate Gatsby’s compensation policies – including stock options! I wrote this article because when I tried to learn about stock options a few years ago, I had trouble finding resources that were both informative and easy to digest. Today I talk to people frequently who have experienced this same situation. It’s why we do a seminar called “Introduction to Stock Options” for all new hires at Gatsby. For those not at Gatsby, I hope this blog post can shed some light on what can be a tricky subject.