Before delving into the finer details of Employee Stock Options ESOs , it is crucial to have an understanding of basic option terms. The call buyer thus benefits when the underlying security or asset increases in price. For a call buyer, option exercise means executing the right to buy the underlying security at the exercise price or strike price.
For a put buyer, option exercise means executing the right to sell the underlying security at the exercise price or strike price. Exercise Price or Strike Price: The price at which the underlying asset can be purchased for a call option or sold for a put option ; the exercise price or strike price is determined at the time of formation of the option contract.
The last day of validity for an options contract, after which it expires worthless. The time left to expiration is a key determinant of the price of an option; in general terms, the longer the time to expiration, the higher the option price. In the money ITM: A term that indicates the option has intrinsic value, i. A call has intrinsic value if the market price of the underlying asset is higher than the exercise price.
A put has intrinsic value if the market price of the underlying asset is lower than the exercise price. The premium is paid up front by the buyer at the time of option purchase and is not refundable. The difference between the market price of the underlying security and the exercise price of the option, at the time of exercise.
For an option with zero intrinsic value, the full premium is attributable to time value. The grantee — also known as the optionee — can be an executive or an employee, while the grantor is the company that employs the grantee. The grantee is given equity compensation in the form of ESOs, usually with certain restrictions, one of the most important of which is the vesting period.
The vesting period is the length of time that an employee must wait in order to be able to exercise his or her ESOs. Why does the employee need to wait? Because it gives the employee an incentive to perform well and stay with the company.
Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant. Note that the stock may not be fully vested in certain cases, despite exercise of the stock options, as the company may not want to run the risk of employees making a quick gain by exercising their options and immediately selling their shares and subsequently leaving the company.
The options agreement will provide the key details of your option grant such as the vesting schedule, how the ESOs will vest, shares represented by the grant, and the exercise or strike price.
If you are a key employee or executive, it may be possible to negotiate certain aspects of the options agreement, such as a vesting schedule where the shares vest faster, or a lower exercise price. It may also be worthwhile to discuss the options agreement with your financial planner or wealth manager before you sign on the dotted line.
ESOs typically vest in chunks over time at pre-determined dates, as set out in the vesting schedule. As mentioned earlier, we had assumed that the ESOs have a term of 10 years. This means that after 10 years, you would no longer have the right to buy shares; therefore, the ESOs must be exercised before the year period counting from the date of the option grant is up.
It should be emphasized that the price you have to pay for the shares is the exercise price or strike price specified in the options agreement, regardless of the actual market price of the stock. Withholding tax and other related state and federal income taxes are deducted at this time by the employer, and the purchase price will typically include these taxes in the stock price purchase cost. You would need to come up with the cash to pay for the stock.
This is a nice problem to have, especially if the market price is significantly higher than the exercise price, but it does mean that you may have a cash-flow issue in the short term. Cash exercise — wherein payment has to be made in cash for shares purchased by exercise of an ESO — is the only route for option exercise allowed by some employers.
However, other employers now allow cashless exercise , which involves an arrangement made with a broker or other financial institution to finance the option exercise on a very short-term basis, and then have the loan paid off with the immediate sale of all or part of the acquired stock. We now arrive at the ESO Spread. As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread.
This spread is taxed as ordinary income in your hands in the year of exercise, even if you do not sell the shares. The ability to buy shares at a significant discount to the current market price a bargain price, in other words is viewed by the IRS as part of the total compensation package provided to you by your employer, and is therefore taxed at your income tax rate.
Thus, even if you do not sell the shares acquired pursuant to your ESP exercise, you trigger a tax liability at the time of exercise. The value of an option consists of intrinsic value and time value. Time value depends on the amount of time remaining until expiration the date when the ESOs expire and several other variables.
Given that most ESOs have a stated expiration date of up to 10 years from the date of option grant, their time value can be quite significant. While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them.
To calculate the time value for your ESOs, you would have to use a theoretical pricing model like the well-known Black-Scholes option pricing model see ESOs: You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO.
From there, it is a simple exercise to calculate time value, as can be seen in Table 2. The exercise of an ESO will capture intrinsic value but usually gives up time value assuming there is any left , resulting in a potentially large hidden opportunity cost. The value of your ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, time to expiration, and above all, volatility.
Consider a situation where your ESOs are out of the money, i. It would be illogical to exercise your ESOs in this scenario for two reasons. Dictionary Term Of The Day. A reduction in the ownership percentage of a share of stock caused by the issuance Broker Reviews Find the best broker for your trading or investing needs See Reviews.
Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. Introduction Employee Stock Options: The option grant itself is not a taxable event.
The grantee or optionee is not faced with an immediate tax liability when the options are granted by the company. Taxation begins at the time of exercise.
The sale of the acquired stock triggers another taxable event. If the employee sells the acquired shares for less than or up to one year after exercise, the transaction would be treated as a short-term capital gain and would be taxed at ordinary income tax rates. If the acquired shares are sold more than one year after exercise, it would qualify for the lower capital gains tax rate. Employee stock options are a form of equity compensation granted by companies to their employees and executives.
But is there another solution? We look at strategies to help manage taxes and the exercise of incentive and non-qualified stock options. Stock options can be lucrative for employees who know how to avoid unnecessary taxes.
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