Types of stock options

What are the various types of stock options?

• Incentive stock options (ISO) - An incentive stock option (ISO) is a valuable corporate benefit that provides employees with the right to purchase shares of company stock at a strike price. Incentive stock options also provide the potential for tax breaks on the profit. The profit on qualified ISOs is usually taxed at a lower rate known as the capital gains rate, not the higher rate used for ordinary income. Employees typically have 10 years from the grant date to exercise ISOs before they expire.
  
  Companies offer incentive or statutory stock options as a way to encourage employees to stay with the company and contribute to its growth and development. This contributes to the subsequent rise in the company's overall stock price.
  
  The strike price is the price at which the stock options are issued, and it is determined based on the value of the company on the date of issuance. The date of issuance is also known as the grant date, and employees have the ability to exercise their rights to buy the options on the exercise date. We'll explain the exercise process in more detail below.
  ‍
• Non-qualified stock options (NSO) - A non-qualified stock option (NSO) functions similarly to an ISO, with the key difference being the method of taxation. While ISOs are taxed as capital gains, NSOs are taxed at the higher income tax rate. Unlike the typical ISO exercise period of 10 years, NSOs have a unique deadline set by the company in which the employee can exercise. If shares are not exercised prior to the deadline, the employee loses the options.
  
  Like ISOs non-qualified stock options are issued on a grant date, and the strike price (the price employees pays to exercise the shares) is typically determined based on the valuation of the company at the time the NSOs are issued.
  ‍
• Restricted stock unit (RSU) - Restricted stock units function slightly differently from ISOs and NSOs. Unlike stock options, RSUs do not require exercising. As a result, employees are not required to pay a strike price to obtain the shares. Once the RSUs have vested, the employee owns the shares and has the right to sell them at the fair market value of the company. We describe the vesting processes in more detail below.
  
  Since no price is paid to acquire the restricted stock units, they are valuable as long as the value of the company is greater than $0. The selling of restricted stock units is taxed at the higher income tax rate.

Value of equity

How do I calculate the value of my equity?

Calculating the value of equity is fairly straightforward. We'll just need to consider your strike price (for ISOs and NSOs), the number of shares issued, and the fair market value of the company.

• Strike price - Strike price refers to the price an option holder must pay in order to exercise their shares. Exercising or paying for the shares means the employee now owns the shares, and gains the right to sell them at the current fair market value (FMV) of the company. Strike price is typically determined by the fair market value (FMV) of the company at the time the stock options are granted.
  
  It's important to remember that strike price does not change over time. The cost to exercise and own your shares will remain the same no matter how the value of the company changes.
  ‍
• Fair market value (FMV) - FMV refers to the current price buyers are willing to pay for the shares of the company. This is the price that exercised shares can be sold for.
  
  The FMV changes in relation to growth. As a company becomes more valuable, the FMV increases. If the business declines and becomes less valuable, the FMV of the shares will decrease as well.
  ‍
• Number of shares issued - number of shares issued reflects the quantity of shares that have been offered in an option grant.
  
  To calculate the total cost to exercise, multiply the number of shares issued times the strike price of one share.
  
  Ex. 2,000 ISOs issued at a strike price of $1.25 = a total cost to exercise of $2,500
  
  Similarly, the potential value of your shares is calculated by multiplying the number of shares owned, by the FMV of one share of the company.
  
  Ex. 2,000 ISOs at a current FMV of $12.00 = $24,000
  ‍
  

To calculate the total value of equity:
Using the example above, we paid $2,500 to exercise or own the shares, which can now be sold at an FMV price of $24,000. The total value is calculated by subtracting the cost to exercise ($2,500) from our selling price ($24,000) resulting in a total value of$21,500.

Ideally, the company will grow over time, resulting in the FMV rising. As the FMV increases while the strike price remains the same, the total value of your equity increases.

The calculation for RSUs is much simpler since no cost to exercise is required. To calculate the total value of an RSU grant, multiply the number of shares owned by the current FMV of the company.

Vesting

What's a vesting schedule?

Vesting refers to the predetermined schedule which dictates when an employee can take advantage of their equity. Typically vesting is based on a 3-5 year period, and encourages employees to work at the company for longer periods of time.

Some employers allow for early exercise which gives employees the ability to pay the strike price to own their ISO and NSO shares prior to vesting, but shares can only be sold once they are considered vested. If an employer does not allow for early exercising, shares must be vested before they can be exercised and sold. We describe three of the most popular vesting schedules below.

• Cliff vesting - Shares do not vest until the cliff is met. Once the cliff is met a lump sum of shares become vested, and the remaining portion of shares begin vesting gradually.
  
  Ex. A 4 year vesting schedule is offered with a one year cliff. The employee receives no shares until they reach one year of employment. On the day of one year of employment, the employee gains 25% of their shares immediately. For the remaining 3 years, shares vest incrementally each month, totaling 100% by the end of year 4.
  
  This is a popular method as it discourages employees from leaving prior to working for at least one year, since they would leave with no equity.
  ‍
• Graded vesting - Shares vest gradually throughout the entire vesting schedule.
  
  Ex. A 4 year vesting schedule is offered. An equal number of shares will begin vesting each month totaling 100% by year 4. Vesting schedules can be graded such that 10% of shares vest in year 1, 25% vest in year 2, 25% vest in year 3, and 40% vest in year 4. They can also be graded equally such that 25% vest equally in years 1, 2, 3, and 4.
  ‍
• Immediate vesting - Immediate vesting refers to immediate ownership of shares. An employee has the right to exercise and sell the shares from the day they are granted.

Selling shares

When can I sell my shares?

• Stock options - Once ISOs or NSOs have been exercised and vested, you have the right to sell your equity. The process is different depending on the stage of the company.
  
  For private companies, you will need to arrange for the purchase of your shares with a private buyer at an agreed upon price. As this process can be complicated, it's recommended that you work with your personal advisor to discuss the potential of selling your shares privately.
  
  For companies that have went public, the process is typically easier, as the public market where your company becomes listed is highly liquid. This means there's a large number of potential buyers willing to accept your equity.
  ‍
• Restricted stock - Employees gain the ability to sell restricted stock units (RSU) as soon as they vest. Since restricted stock is taxed immediately upon vesting, many employees choose to sell them right away as there is no tax benefit to holding on to the stock longer. Some employees choose to hold on to their RSU after they vest, in hopes that the value of the stock will increase in the future.
  
  As RSUs are often reserved for later stage private and public companies, RSU holders frequently benefit from the ability to sell the stock efficiently on the public markets. If the company is private at the time the RSUs vest, employees would need to arrange a private transaction to sell the shares similar to ISOs or NSOs.

Taxes

How do taxes impact my equity?

• Statutory stock options - Statutory stock options are granted under an employee stock purchase plan, also known as an incentive stock option (ISO) plan.
  
  The grant of an ISO or other statutory stock option doesn't immediately produce any income subject to normal income taxes. Similarly, the exercise of the option to obtain the stock does not produce any immediate income as long as you hold the stock in the year you acquire it. Capital gains tax results when you later sell the stock acquired by exercising the option.
  
  Exercising an ISO does produce an adjustment for purposes of the alternative minimum tax, or AMT. The adjustment for AMT is calculated based on the difference between the strike price paid for the stock and the FMV of the stock acquired.
  
  If you sell the stock in the same year you exercised the ISO, no AMT adjustment is required. This is because the tax treatment becomes the same for regular tax and AMT purposes. Our advisors will help you calculate your potential alternative minimum tax, and create strategies to minimize or avoid the tax altogether.
  ‍
• Nonstatutory stock options - Nonstatutory stock options, also known as non-qualified stock options (NSO), are granted without any type of plan.
  
  There are three events for nonstatutory stock options, each with their own tax results: Grant of the stock option, the exercise of the option, and the sale of stock acquired through the option exercise.
  
  If the FMV of the stock options is readily able to be determined, then the receipt of these options is immediately taxable. In many cases an ascertainable value is unavailable, leading to no immediate tax from the grant of the option.
  
  When exercising the option the FMV of the stock is required to be reported as income minus the amount paid for the options. This is treated as typical wage income reported on the W2, which leads to an increased tax basis on the stock.
  
  When the shares are later sold, you report a capital gain or loss for the difference between your tax basis and what you receive on the sale.
  ‍
• Restricted stock - Restricted stock and RSUs are taxed differently than other kinds of stock options, such as statutory or non-statutory employee stock purchase plans.
  
  restricted stock usually becomes taxable upon the completion of the vesting schedule. For restricted stock plans, the entire amount of the vested stock must be counted as ordinary income in the year of vesting.
  
  The amount that must be declared is determined by subtracting the original purchase or exercise price of the stock (which may be zero) from the fair market value of the stock as of the date that the stock becomes fully vested. The difference must be reported by the shareholder as ordinary income.
  
  However, if the shareholder does not sell the stock at vesting and sells it at a later time, any difference between the sale price and the fair market value on the date of vesting is reported as a capital gain or loss.
  ‍

The bottom line: Stock options are a powerful benefit, but the tax rules are complex. Speaking with your compdesk advisor is essential to create a plan and determine how these taxes impact you.