Understanding your options

Stock options checklist

By Johanna Schlegel
Reprinted from Salary.com

Salary.com's compensation experts have put together a checklist of the ten most important questions you should be able to answer about your stock options. Use this checklist as you prepare your research for a salary negotiation, or at your next performance review, or when you are in line for a promotion. Some of these questions are essential to understanding the value of your stock options award, and others simply help explain the implications of certain events or situations.

Don't be surprised if you have options now and can't answer some of these questions - they're not all obvious, even to people who have received stock options before.

The answers provided here are relevant for people from the United States. If you are not from the United States, the tax information and some of the trends discussed may not be relevant to your country.

The ten most important questions about your stock options are as follows.

• What type of options have you been offered?
• How many options do you get?
• How many shares in the company are outstanding and how many have been approved?
• What is your strike price?
• How liquid are your options, or how liquid will they be?
• What is the vesting schedule for your shares?
• Will you get accelerated vesting if your company is acquired or merges with another company?
• How long must you hold your shares after an IPO, merger, or acquisition?
• When you exercise your options, do you need to pay with cash, or will the company float you the exercise price?
• What kinds of statements and forms do you get or do you need to fill out?

1. What type of options have you been offered?
In the United States, there are essentially two types of stock options: incentive stock options (ISOs) and nonqualified stock options (NQSOs). The primary difference between the two with respect to the option holder is the tax treatment when the option is exercised.

When you exercise ISOs, you do not normally have to pay any taxes (although there is a chance you may be required to pay an alternative minimum tax (AMT) if your gain is large enough and/or certain other circumstances apply). You will eventually have to pay taxes on this gain, but not until you sell the stock, at which time you will pay capital gains taxes (the lesser of your marginal rate or 20 percent) on the total gain - the difference between the amount you paid to exercise the option and the amount for which you ultimately sold the stock.

Remember, though, you must hold the stock for at least a year after you exercise the option to protect this tax break. Otherwise your incentive stock option will automatically become a nonqualified stock option and you will have to pay ordinary income tax.

When you exercise nonqualified stock options, you are required to pay ordinary income taxes on your gain as of the time you exercise the option. This tax is based on your marginal tax rate (between 15 and 39.6 percent). When you eventually sell the stock, you will have to pay capital gains taxes (the lesser of your marginal rate and 20 percent) on the gain you realize between the market price on the day you exercise and the market price on the day you sell the stock.

The U.S. government is considering allowing companies to offer a new type of stock option called a super stock option. If this is approved and your company meets certain requirements, you may receive a super stock option, which would be similar to an incentive stock option.

Insights. Companies offer nonqualified stock options for a few reasons. There are a number of restrictions on when and how many incentive stock options a company can grant, as well as the conditions for those options. For example, if the company issues stock options with an exercise price below the actual share price, those options cannot be incentive stock options. Also, the company receives a tax deduction for nonqualified stock options, but not for incentive stock options. The deduction helps reduce the company's tax burden and therefore can help increase the value of the stock.

2. How many options do you get?
The number of stock options you receive is a function of several variables. Option grant sizes depend on your job, the frequency of the grants, the industry, the company's philosophy, the company's size, the company's maturity, and other factors. In a high-tech startup, for example, the grant you receive is generally much larger as a percent of the company's total shares outstanding than a grant you would receive from a more mature, established company. But often when a company is awarding a large number of shares, it is because there is more risk associated with them.

Insights. People often have a hard time comparing option grants from various job offers. Don't focus solely on the number of shares you're being granted. Try to keep in mind their potential value to you and the likelihood that they'll achieve that value. For a startup, your options may have an exercise price of $5 or $1 or even 5 cents per share, but at some point a year or two from now, those shares could be worth $50 or $20 or $10 or even nothing. Presumably less risky are options from mature companies that provide more stability but also less chance of a "home run." In these companies, look at the exercise price of the options and how you think the stock will perform over some period of time. And remember, a 10 percent increase in a $50 stock is worth $5, whereas a 10 percent increase in a $20 stock is worth $2.

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