By John Drachman
Many companies offer their most-favored employees an attractive pair of golden handcuffs – stock option plans – designed “to compensate, retain, and attract new talent,” according to the Securities and Exchange Commission’s website. By giving employees skin in the game – a chance to buy stock – employers are hoping to motivate staff to amp up their performance to increase the firm’s value to its equity shareholders.
Depending on the market and the company’s fortunes, such golden handcuffs can be worth a lot of money. Before slipping on those golden handcuffs, though, take a moment to familiarize yourself with a few key terms:
- Stock options: When an employer gives you stock options, it’s giving you the right, but not the obligation, to buy shares of the company at a specified price or strike price on or before the option’s expiration date – typically several years down the road. Often the strike price is at a discount to what the shares were worth on the market when the options were granted.
- Vesting time: Vesting is the amount of time you have to be employed before you can exercise your stock options. Usually 20% to 25% of your grant vests every year. Smart employers know many of their most valuable employees will be incented to stay with their company at least until the date shares are fully vested – or after the date the options expire.
- Exercising an option: To exercise an option means you’re actually buying the shares you’re entitled to at the strike price. Your options are considered to be “in the money” when the current market price of the stock is greater than the strike price. The right time to exercise your options is dependent on your personal circumstances and tax situation.
- Fair market value: This is the price your shares would be worth if sold on the open market on the day you exercised your stock options. The difference between strike price and the fair market value signals how much you’ll gain, as well as the potential tax impact.
- Two kinds of stock options: Non-qualified and incentive: With non-qualified stock options, taxes are often withheld from your proceeds at the time you exercise your options. This is not the case for incentive stock options in which you pay capital gains taxes after you sell your shares at a profit.
What to do next
All employee stock option plans will have a plan document that spells out the rules of the road. After reading it, consider speaking with a financial planner familiar with these plans. In addition to determining the most favorable time to exercise your options, there are other factors to consider; such as investment risk, tax planning, and your personal financial circumstances. “Being passive about stock options, or ‘winging it,’ can easily turn a good situation into a bad one,” says Jeff Watkins, CPA, JD. “Careful tax planning over a period of years is needed to effectively manage potential stock option risks and maximize the benefits.”
John Drachman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. John is an IABC award-winning writer, who applies his 30 years of financial marketing experience toward advancing the dialog between investors and investment professionals.