Key Takeaways

  • Common Stock Options give employees the right to buy company stock at a predetermined price, offering the potential for profits if the stock price rises.
  • Types of Stock Options include Incentive Stock Options (ISOs) and Non-Incentive Stock Options (NISOs), each with different tax advantages and requirements.
  • Vesting Schedule: Most stock options come with a vesting schedule to encourage long-term employee retention, typically over 3-5 years, with some options featuring cliff vesting.
  • Exercise Price: The price at which the employee can buy the stock, often set to the fair market value on the grant date, which has tax implications.
  • 409A Valuation: Private companies often require an independent valuation to determine the fair market value of stock options to ensure compliance with tax regulations.
  • Early Exercise: Some options allow early exercise, but this can complicate tax treatment, often leading to "reverse vesting" for unvested stock.

Common stock options are merely options to purchase stock at a later date in time. Specifically, options are those sold by one party to another party that allow the potential purchaser to exercise the right to buy the options at a previously agreed price. The option to buy usually has an expiration date of 30-90 days in the future.

Option Types

There are different types of options that can be used, including the following:

  1. Puts and calls
  2. Writing options
  3. Employee stock options

Call

A call occurs when someone has an option to purchase shares at a certain price before the option to purchase expires. A put occurs when the buyer can sell stock at a certain price before the expiry date.

With regard to a call option, the purchaser assumes that the stock will increase in price, while the seller of the stock assumes that the stock will actually decrease. Therefore, the seller wants to make money on the call option by selling it at what he thinks is a higher price since he believes the stock will decrease. The buyer, however, believes that the stock will continue to increase, and will therefore think he is getting a great deal on purchasing the stock at the agreed upon price identified in the call option.

For example, let’s assume that ABC Company stock is selling at $100 per share. If the strike price (the option price) is $95, the trader will initially buy the option for $8. Thereafter, during the time when the option is open, the stock raises to $105. In this case, the trader will make a net profit of $2 based on the difference between the prior stock price of $95, the new stock price of $105, and the amount the trader paid for the initial option, which was $8. The most the trader can lose out on any options contract would be the amount he or she paid for the initial option. In this case, it would be $8.

Put

If the trader believes the stock will reduce in value, he can purchase a put option giving him the right to sell the stock at the strike price before it expires. If the stock does in fact reduce in value, the trader will earn a profit. An example of this would be if the strike price is $50, but the trader pays $3 for the initial option. If the stock falls to $45 by the expiration date, the trader will then earn a net profit of $2 for each share. This might be quite substantial depending on how many shares are involved in the initial option contract.

Keep in mind that the more volatile the stock is, the greater the cost of the option for the trader.

Writing options

Some traders might want to buy options whereas others might have to write them. The writer of the actual option contract receives a premium for writing the option. This is the maximum profit that can be made on the option. But the writer assumes the risk of having to buy or sell the shares from the buyer at the strike price. This could be a big loss for the writer. For example, if a trader writes a call option, the option buyer can purchase the option at the strike price. Let’s assume that the strike price is $5, but the price of the stock increases to $30. The writer still has to provide the option buyer with the option to purchase the shares at $5. This means that if the option is exercised before the expiration date, the buyer will significantly benefit, and the writer (the trader) will have suffer a financial loss.

Employee Stock Options

Employee stock options are similar to that of a call or put option. The differences are in that the employee stock options usually vest at a certain point in time, rather than expire. This means that the stock options will mature at which point the employee will have full ownership over the shares and not have to return them or lose their ownership rights upon leaving the company. For example, some companies might require that an employee work for the company for a period of at least 3-5 years before vesting. If the employee leaves before the vesting date, they will lose their ownership rights over the stock.

Common Stock Options and Their Tax Implications

When an employee is granted common stock options, they are typically given the right to purchase shares at a set price, known as the exercise price. The key benefit of stock options is that they allow employees to potentially purchase shares at a discount if the company's stock value increases.

There are two primary types of stock options: Incentive Stock Options (ISOs) and Non-Incentive Stock Options (NISOs).

  • Incentive Stock Options (ISOs) are typically tax-advantaged. There is no immediate tax liability when these options are granted or exercised, but employees could face tax implications when they sell the shares if the holding period requirements are met.
  • Non-Incentive Stock Options (NISOs) do not have the same tax advantages. When exercised, the difference between the exercise price and the fair market value is subject to income tax and payroll taxes.

The exercise price is usually set at the fair market value of the stock on the date the option is granted. For private companies, determining the fair market value can be complex, and companies often hire independent valuators for a 409A valuation to ensure the exercise price is set correctly.

Common Stock Options in Private and Public Companies

In both private and public companies, stock options are typically issued for common stock. In public companies, the market value of common stock is determined by its trading price on the stock exchange, making valuation straightforward. In contrast, private companies must rely on methods like a 409A valuation to determine the fair market value of their common stock before issuing options.

In early-stage private companies, stock options for common stock may be granted at a significant discount to the preferred stock price. This discount reflects the higher risk and lack of liquidity associated with the company’s shares. As the company matures, the difference in price between common and preferred stock should narrow.

Vesting and Tax Considerations for Stock Options

One important aspect of stock options is the vesting schedule, which dictates when employees can exercise their options. A vesting schedule ensures that employees must stay with the company for a certain period before they can fully benefit from their stock options. A typical vesting period lasts 3-5 years.

Cliff vesting is a common type of vesting schedule where employees must work for a set period, such as one year, before any of their options vest. Once the cliff period ends, a large portion of the options typically vest at once, and the remaining options continue to vest monthly or quarterly.

Taxation of stock options depends on the type. For ISOs, there is no tax at the time of grant or exercise. However, employees may face taxes if they sell their shares before meeting the holding period requirements. In contrast, NISOs are taxed when exercised, with the difference between the exercise price and the fair market value treated as ordinary income.

Frequently Asked Questions

  1. What are common stock options?
    Common stock options give employees the right to purchase company stock at a predetermined price, allowing them to benefit if the stock price increases.
  2. How do common stock options differ from employee stock options?
    Common stock options are a broader category, whereas employee stock options typically refer to options granted to employees of a company, often with specific tax advantages or vesting schedules.
  3. What is the tax treatment of stock options?
    For Incentive Stock Options (ISOs), there is no immediate tax upon exercise, but the sale of the stock may trigger taxes. For Non-Incentive Stock Options (NISOs), the difference between the exercise price and the stock's market value is taxed as ordinary income.
  4. What is a 409A valuation?
    A 409A valuation is an independent assessment of the fair market value of a private company's stock, often used to determine the exercise price of stock options.
  5. What is cliff vesting?
    Cliff vesting is a type of stock option vesting where no options are exercised until a specific period, such as one year, after which a portion of the options vest.

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