How do incentive stock options work?

April 20, 2011 7:20 PM

Incentive stock options: explain them to me as if were a child!

Starting a new job, received some incentive stock options. Now how on earth does this work? Here's the phrasing:

"...2,500 shares of the common stock of [company] at the fair market value determined at the meeting. This option shall be exercisable with
respect to a four year installment vesting period with a one year cliff (25% after one year, 2.083% per month thereafter)."

I have no mind for this kind of stuff, so please explain this to me without using any confusing financial jargon. What are my next steps in this game?

posted by kmtiszen to Work & Money (15 answers total)

Best answer: Next steps don't really matter at this point. You just sign the document they give you, and you may want to file something with the IRS to pay taxes on the shares now instead of when the shares vest. (This is called an 83(b) election and you should be able to ask your company about whether it's advisable and how to do it.)

When the options become exercisable, you can buy shares of the company at the exercise price.

The options aren't exercisable until they vest. None of the options will be vested until you've been at the company for a year, so if you leave before the first year, you lose them. (This is the one-year cliff). After the first year, additional shares vest monthly.

For instance, suppose the fair market value at the time of issuance is $1/share, and you are granted 1,000 options. After you've been at the company for a year, 250 of the options become exercisable. For each additional month you're there, an additional 20 (give or take) options become exercisable until all the options vest. At any time after options become exercisable, you can choose to exercise any or all of them by buying shares of common stock at $1/share.
posted by chickenmagazine at 7:29 PM on April 20, 2011

Best answer: you have the right but not the obligation to buy shares at a price to be determined at the meeting. There should be a formula they can give you that determines "fair market value". These options will become yours, and eligible for you to use to buy shares at the previously agreed price over the next four years, with the first 25% becoming yours in one year, and the remainder becoming yours at the rate of ~2% a month for the remaining 36 months.

Basically the cash you put in your pocket will be the difference between the share price and the "fair market value" price at the time you exercise the options, but you can't exercise any options that have not "vested". Vested is jargon for "Its now yours"
posted by JPD at 7:29 PM on April 20, 2011

Best answer: Suppose your company's stock is trading at $10/share today.
Suppose a year from now, it is trading at $15/share.
You can exercise 625 options (1/4 of 2500) and buy your company's stock at $10/share, then turn it around and sell it at $15/share, netting 625 shares * $5/share profit.

If your company's stock goes under, the options are "underwater" and not worth anything.

If you leave the company, you typically forfeit the options.

Hope that helps!
posted by elmay at 7:29 PM on April 20, 2011

Response by poster: I think that's all the info I need for now. Thanks all!
posted by kmtiszen at 7:35 PM on April 20, 2011

In addition to the above, incentive stock options have different tax rules from nonqualified stock options. Make sure you know which type you have when you do your taxes, as there is an actual downside for selling ISOs less than a year after you buy the stock.
posted by mkb at 7:39 PM on April 20, 2011

Wait, there's more. The one thing you need to keep in mind is that when most people get stock options through work, these are non-qualifying options, and the rules and tax implications are significantly different in those cases.

chickenmagazine is right to bring the 83(b) election to your attention, because this can make a big difference when it comes to tax time. There are 2 other options (keep in mind I'm not a tax lawyer, financial planner, or accountant and you need to double- and triple-check all of this): one, exercise and sell shares immediately after vesting. The money you get here will be taxed at regular rates. Another one is to wait a year and a day after vesting to exercise and a year and a day after exercising to sell. The tax rates you will pay will be much lower (if I remember correctly, you only pay the long-term capital gains tax on the appreciation during the period you hold the stocks). The downside is that the value of the shares minus exercise price will count towards the alternative minimum tax (AMT). This can be a big deal.
posted by UrineSoakedRube at 7:41 PM on April 20, 2011

So one other thing I forgot to mention above: if you (say) join up now and your startup (you didn't say if this company is a startup, but ISOs are usually granted to startup employees) goes public or gets bought out 3 years from now, you may want to consider exercising your options before this happens, as you can get a jump start on the time required to sell shares at the favorable tax rates.

I don't want to put words in their mouths, but I think chickenmagazine, JPD, and elmay would agree: the information they gave is only the barest starting point, and you need to discuss this with a professional. You may want to use your next AskMe to find out who in your area is a good person to talk to about this and how much you can expect to spend on a consultation.
posted by UrineSoakedRube at 7:47 PM on April 20, 2011

See this recent thread for more on the AMT.
posted by jeffamaphone at 7:55 PM on April 20, 2011

Get a copy of Consider Your Options, it's a truly fantastic resource for understanding employee stock options. It'll help you tremendously in knowing the right questions to ask if/when you talk to a financial pro.
posted by kanuck at 8:55 PM on April 20, 2011 [1 favorite]

If you want to be able to meaningfully evaluate the value of your stock options, you need to understand just how much of the company you're getting. 2500 options may sound like a lot, but if there are 25,000,000 outstanding shares, then it's not too much. Generally you should think about "percentage of the company" rather than "number of options". The average sale of a startup that doesn't go out of business is roughly $50 million. So for example, if you have options to 1/10000 of the company, that'll net you a cool 5 grand.

(There are other factors to consider too, when valuing your options, such as the fact that VCs will get priority when the company is sold up (this is called a "liquidation preference"), so your options may be totally worthless even if the company sells for a per-share price that would appear to make you money.)
posted by alexallain at 8:56 PM on April 20, 2011

Is the company publicly traded? It makes a huge difference in how the options effectively work whether there is a liquid market for the company stock or not.
posted by phoenixy at 6:15 AM on April 21, 2011

Another one is to wait a year and a day after vesting to exercise and a year and a day after exercising to sell. The tax rates you will pay will be much lower (if I remember correctly, you only pay the long-term capital gains tax on the appreciation during the period you hold the stocks). The downside is that the value of the shares minus exercise price will count towards the alternative minimum tax (AMT). This can be a big deal.

The other downside is that you actually need that cash available, and will tie it up for a year. This can be quite a lot of money for 2500 shares, or a significant portion thereof.
posted by smackfu at 10:07 AM on April 21, 2011

smackfu: "The other downside is that you actually need that cash available, and will tie it up for a year. This can be quite a lot of money for 2500 shares, or a significant portion thereof."

Some brokers offer a single "exercise and sell to cover" option which will sell off just enough shares to cover your taxes and the cost of buying the shares in the first place.
posted by mkb at 10:49 AM on April 21, 2011

The other downside is that you actually need that cash available, and will tie it up for a year. This can be quite a lot of money for 2500 shares, or a significant portion thereof.

In this case, 625 shares (one quarter vests each year). Which can still be a significant amount, but in my experience and what I've heard generally is that ISO strike prices tend to be fairly low.
posted by UrineSoakedRube at 4:04 PM on April 21, 2011

Indeed, good points. I was thinking of stock options for an established company, where you may be dealing with stock priced at $100 that you are trying to get a $10/share gain out of.
posted by smackfu at 6:02 AM on April 22, 2011