Stock options are a powerful tool for compensation and wealth-building, particularly for employees of high-growth startups and private companies. They offer the right—but not the obligation—to purchase shares at a fixed price, known as the exercise price or strike price.
Because stock options have an expiration date, employees and shareholders must carefully plan when and how to exercise them to maximize value and minimize tax liabilities. Understanding the mechanics of stock options, including vesting schedules, taxation, and different option types, is essential for making informed financial decisions.
This guide breaks down the fundamentals of employee stock options, key terms you need to know, and strategies for exercising and managing options effectively.
What Are Employee Stock Options?
Employee stock options (ESOs) give employees the right to purchase company stock at a predetermined price, providing an opportunity to benefit from the company’s future growth. Unlike receiving stock outright, options must be earned over time through a vesting schedule and exercised before they expire.
Why Companies Grant Stock Options
- Attracting and retaining talent – Equity incentives align employees with the company’s success.
- Delaying cash compensation – Companies, especially startups, can offer options instead of higher salaries.
- Encouraging long-term commitment – Employees benefit as the company grows, motivating them to stay and contribute.
Because stock options come with specific rules around vesting, taxation, and expiration, it’s important to understand how they work before making financial decisions.
Types of Employee Stock Options
There are two primary types of stock options issued to employees:
Incentive Stock Options (ISOs)
ISOs offer favorable tax treatment under U.S. tax laws but come with strict qualification requirements.
- Only available to employees (not contractors or advisors)
- Preferential tax treatment if held for at least one year after exercise and two years after grant
- No immediate tax liability upon exercise unless subject to the alternative minimum tax (AMT)
Non-Qualified Stock Options (NSOs)
NSOs are more flexible than ISOs but come with higher tax obligations at the time of exercise.
- Available to employees, contractors, and advisors
- Taxed as ordinary income at exercise, based on the difference between the strike price and the stock’s fair market value
- No AMT implications, but no special tax benefits either
Companies often grant NSOs to non-employees and ISOs to employees to take advantage of potential tax benefits.
Key Stock Option Terms to Know
Option Grant Agreement
The formal agreement outlining the number of options granted, strike price, vesting schedule, and expiration date.
Strike Price (Exercise Price)
The fixed price at which an employee can buy shares, regardless of the current market value.
Vesting Schedule
The timeline over which employees earn their options. Most startups use a four-year vesting schedule with a one-year cliff, meaning employees earn 25% of their options after one year, with the remainder vesting monthly or quarterly over the next three years.
Market Value
The price at which a share of stock trades on the open market. For private companies, this is determined by 409A valuations.
In-the-Money (ITM) vs. Out-of-the-Money (OTM)
- ITM: The stock’s current price is higher than the strike price, making the option valuable.
- OTM: The stock’s current price is lower than the strike price, meaning there is no immediate financial benefit to exercising.
Expiration Date
The date by which stock options must be exercised before they become worthless, typically ten years from the grant date for employees still with the company.
How Do Stock Options Work?
To better understand how stock options function, let’s consider an example:
Example: Exercising Employee Stock Options
Emma is a software engineer at a fast-growing startup. As part of her compensation package, she receives an option grant for 30,000 shares of company stock at a strike price of $3 per share.
- Her options vest over four years with a one-year cliff. After one year, 7,500 shares (25%) vest. The remaining shares vest monthly over the next three years.
- Three years later, the company’s stock is worth $15 per share. Emma now has the right to purchase all 30,000 shares at $3 each, for a total cost of $90,000.
- Her potential profit, if she exercises and sells immediately, would be:
- (30,000 shares × $15 market price) – (30,000 shares × $3 strike price) = $360,000 profit
If Emma waits longer to exercise, she risks the company’s stock price fluctuating. If she leaves the company, she typically has 90 days to exercise before losing her vested options.
How to Exercise Stock Options
There are multiple ways to exercise stock options, each with different financial and tax implications:
1. Cash Exercise
The option holder pays cash upfront to buy shares at the strike price. This method requires capital but allows the employee to hold shares for long-term appreciation.
2. Cashless Exercise
For public companies, employees can sell some shares at market price to cover the exercise cost and taxes, avoiding upfront cash payments.
3. Early Exercise (for Private Companies)
Some private companies allow early exercise before vesting, enabling employees to start the long-term capital gains tax clock sooner.
When to Exercise Stock Options
Deciding when to exercise depends on:
- Tax implications – ISOs may be subject to the AMT if exercised before a liquidity event.
- Company growth outlook – If stock value is expected to rise, early exercise could be advantageous.
- Expiration deadlines – Options must be exercised before they expire, typically within 90 days of leaving a company.
Because tax implications can be complex, working with a qualified tax advisor is highly recommended.
How Are Stock Options Different from RSUs?
Restricted Stock Units (RSUs) are another common form of equity compensation, but they differ from stock options in key ways:
- RSUs convert into shares automatically upon vesting, while stock options must be exercised.
- RSUs have no strike price, meaning employees don’t need to purchase shares.
- RSUs are taxed at vesting, while stock options are taxed at exercise and sale.
Many late-stage private companies and public companies favor RSUs over options because they guarantee employees receive equity value, while stock options depend on market performance.
Final Thoughts
Stock options are a powerful tool for wealth creation, but they require careful planning around vesting, taxation, and exercise strategies. Whether you are a founder, early employee, or advisor, understanding your stock options can help you maximize their value while avoiding costly mistakes.
At Veritas Global, we help startups and employees navigate the complexities of equity compensation, stock option agreements, tax strategies, and liquidity planning.
Don’t leave equity on the table. Contact us today to learn how we can help you optimize your stock option strategy and ensure compliance with the latest regulations.
