Employee Stock Options
Many companies offer Employee Stock Options as part of an overall compensation package. Very often by accepting a stock option, you will be taking a lower salary or other reduced compensation in exchange for the stock options. In the dot-com boom, many employees working for internet start-ups exercised their stock option rights and become overnight millionaires. However, in the current economic climate this is unlikely to happen to you, even if you work for a start-up. You need to decide how advantageous it will be to accept stock options, which may depend on why your company is offering you them.
Companies, especially start-ups, offer stock options instead of higher salaries to people joining the company. However, even established companies woo prospective middle and higher management workers with 'golden hello' options to acquire good staff. If you have been working for a firm for a while, you may be offered a stock option package, if funds are tight, instead of a well-deserved pay rise as a way to retain your services. Higher management are sometimes given 'golden parachutes' with stock options as part of a severance package. Some companies may also offer stock options during mergers or restructuring as a way of retaining key staff.
Stock Option Packages
An option is not a stock, it is a right to buy company stock sometime in the future at a price to be determined (the strike price).There are two basic types ISO's or incentive stock options and NQSO's or non-qualified stock options or non-quals. Normally these are in common stock as opposed to preferred stock that outside investors buy.
These are usually offered by startups. They have the advantage for the average person, who doesn't pay AMT (Alternative Minimum Tax), that allows gains made from the sale to not be recognized as income; so you don't have to pay tax.
These type of options are subject to immediate tax when you exercise your option. If you are not careful, or are unlucky, you can make a paper or phantom gain, which then becomes an actual loss, but you still have to pay tax on the phantom gain!
Vestings, Cliffs And Triggers
A vesting schedule is the time scale for exercising your options, while a cliff is the stage at which you can take advantage of your options. For example, a four-year vesting means you can exercise your options in stages over four years. If you have a one-year cliff, you can get the first 1/4 of your options after your first year of employment. Then you can take the rest of your options spread out equally over the remaining three years. If you have several cliffs, you can only take your option after each cliff. Triggers are events accelerate the process, like when a start-up company is acquired by another company. With a single trigger, you acquire all your stock options immediately. With a double trigger package, something else needs to happen as well, like a substantial change in your position in the new company.
The Size Of The Option
What's important isn't the number of shares you are given in the option, but what percentage of the total number of shares in the company you are being offered. Don't forget to include the percentage of preferred shares when making this calculation. Remember that to exercise your option you need to be able to have the money to pay for your stocks, and to pay any applicable taxes as well.