If you’ve been offered a job at a publicly-held company, there’s a good chance your compensation package may include “employee stock options.” Those stock options can have a huge impact on your finances, especially if you plan to stay with the company long-term, so it’s important to know how they work.
What are employee stock options?
Employee stock options mean that, at some future date, you can buy stock at a specified price, no matter what the stock is actually trading for at that time. The idea is that, if the company is successful, you could sell your options at a huge profit. Say, for instance, that you’re given 1,000 shares at the option price of $10. Seven years down the road, the company’s stock is trading at $100. Your option package of 1,000 shares was originally worth $10,000; now it’s worth $100,000.
Why would companies do that?
There are a number of reasons companies include stock options in their compensation packages:
- Some employees are willing to take a lower salary in exchange for stock options, which allows the company to defer costs.
- Stock options give employees a reason to do their jobs well. It’s about ownership. If the company does well, so do the employees.
- Since most compensation packages require employees to hold their stock options for a number of years before they can sell them, those options can help with employee retention (which is why they’re sometimes called “golden handcuffs”).
What if the stock goes down?
You’re not obligated to use your options. If they’re about to expire and the stock price is so low that they’re not worth anything, you can choose to do nothing. You miss out on potential gains, but it doesn’t cost you anything directly.
I’ve been offered two jobs: one with a relative low salary but lots of stock options, and another with a higher salary but no options. How do I choose?
Since nobody can predict with certainty what any single stock will do – even the professionals often get it wrong – you aren’t going to have solid numbers to work with. You’re going to have to factor in potential. If the company has talented employees and a great product in an under-served market, you could have the potential to earn a lot of money. Some employees become millionaires through their stock options. On the other hand, if the company fails, then you’ve taken a lower salary with no benefit. The best advice is to take a hard look at the company’s chances for success. You may even consider going over the company’s financials with a stock advisor to help determine the potential for growth.
How does it work?
The most common way of exercising options is called a “cashless transaction.” While there are some things going on behind the scenes, you basically just put in an order to sell your options. The sale goes through at the current price, and you get a check for the difference between that price and your option price. In the example above, you’d get a check for $90,000:
(1,000 x $100) – (1,000 x $10) = $100,000 - $10,000 = $90,000
Are there any drawbacks?
While it’s always possible that the stock will soar after you sell – which means you’d have gotten a lot more money if you had waited – the main thing to watch out for is the impact on your taxes. In the United States, for example, employee stock options are considered to be regular income rather than capital gains, which means they’re taxed at a higher rate. The additional income could also push you into a higher tax bracket, which would also cost extra money. You’d still come out ahead, but your tax bill could be a nasty surprise if you’ve already spent the money. It’s important to understand how your country’s tax system treats stock options and what that might mean for you.
Stock options have the potential to be the proverbial pot of gold at the end of the rainbow, but that’s certainly not guaranteed. The stock price might drop, which means your options would be worthless. Or, the company could go out of business, meaning you’d be out of your options and your job. It’s up to you to do your due diligence so you’ll have a realistic expectation of how stock options will affect your compensation.