Personal Finance

Understanding Employee Stock Options

Does your new job offer stock options to you? For many it's a great incentive to join a new company. Google (GOOG) has to be the highest-profile example, with the legendary stories of thousands of original employees becoming multi-millionaires, including the in-house masseuse. Below is some information to help you understand stock options a little better if you’re confused about how they work.

How stock options work

Though employee stock options have lost a bit of their luster since the global financial meltdown -- being replaced more and more by restricted stock -- options still account for nearly one-third of the value of executive incentive packages, according to compensation consulting firm James F. Reda & Associates. Want stock options? You’re going to find them harder to find these days, mainly due to changes in the tax laws and recent blow-back from employees working for companies battered by the recession and tired of holding out-of-the-money, worthless options. In fact, employee stock options peaked in popularity back in 1999.

But if you score a gig with options, here’s how it will work.

Being granted stock options gives you the right to buy your company’s stock for a set price at a future date and for a specified time. We’ll use GOOG as an example.

Photo courtesy of iStockExercising stock options

Let’s say you were among those lucky “Nooglers” hired back when GOOG was issuing stock options at $500. You get the right to buy 1000 shares at $500 (the grant price) after two years (the vesting period) and you have ten years to exercise the options (buy the shares).

If Google’s stock price is under $500 when your shares are vested they are out of the money and you’re out of luck. You don’t have to buy the shares at a loss, they just expire worthless, unless the stock rebounds and gets above its strike price -- or if the company generously decides to revalue the original exercise price.

But if GOOG is over $1000, as it is now, crack open the champagne – you’re in the money! You can buy 1000 shares at $500, then sell them and pocket a half million dollar profit. Just watch out for the ensuing tax bill.

In some cases, you can exercise your options and then hold on to the stock for at least a year before selling them and pay a lower tax rate. Options have a bunch of tax consequences to consider. If you have questions about your stock options, ask an advisor.

The downside of employee stock options

In spite of that fact that options can make millionaires out of masseuses, there are some downsides:

  • Stock options can be a bit complicated. For example, different kinds of stock options have different tax consequences. There are non-qualified options and incentive stock options (ISOs), both having specific tax triggers.
  • Options can expire worthless. Imagine the thrill of a grant followed by the agony of a stock flop. Rather than acting as an employee incentive, options issued for a stumbling stock can muck-up morale.
  • Knowing when and how to exercise stock options can be nerve wracking. Has the stock reached its peak? Will it ever rebound from historic lows? Exercise and hold – or exercise and sell?
  • And you can get way too invested in company stock. Holding a heap of options can lead to a windfall or a downfall. You just can’t bank on them until they’re in the money and in your pocket.

Employee stock options can be an extraordinary wealth-builder. With a rising company stock price and a vesting ladder, it’s almost like a forced savings account. And that can be an option worth taking.

Neda Jafarzadeh is a financial analyst for NerdWallet, a site dedicated to helping investors make better financial decisions with their money.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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