Employee Stock Option Basics

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A lot of people don’t maximize their employee stock options (ESO), and understandably so. They’re dealing with a type of investment called a derivative (its value is derived from another investment) and those can be confusing. There is a lot of unfamiliar terminology involved, and these are busy working people who don’t have time to sort it all out. If you have employee stock options, it’s important to have a strategy that makes sense to you in order to receive the compensation you’ve earned. In this post, I’ll give you a few basics to get you started. Next, you’ll want to coordinate with your human resources department, your financial advisor and tax professional to devise an overall strategy that is best for you.

First of all, you need to understand the details of your plan. Ask HR for a plan summary– it’s a good place to start. Here is a primer on employee stock options from a recent FPA Journal article, “How to Help Employees Better Value Stock Options as Compensation.

A stock option is a right to buy a share of company stock for an exercise price (also referred to as a strike price) that extends for a period into the future (the exercise period), but then expires (the expiration date). If the stock price increases during the exercise period, the option increases in value. A person buys an option from a seller, who agrees to sell the stock to the buyer for the exercise price if and when the buyer chooses to exercise the option. As the market price of the underlying stock increases or decreases, the value of the option can swing from being “in-the-money” (the exercise price is less than the stock price) to being “underwater” (the exercise price is more than the stock price).

At the point when the option holder decides it is advantageous to exercise the in-the-money option (who would exercise an underwater option?), he or she can buy the share of stock at the exercise price and immediately resell it for the current market price, making a profit of the difference between the stock and the exercise prices. Alternatively, the option holder can trade the option in one of many exchanges, or can let it expire without exercising it (Broadie and Detemple, 2004).

This explanation seems straightforward enough; however, ESOs get more complicated quickly. Besides the moving price of the company stock, one must also consider the interplay of other factors – for instance, the vesting period. This is the amount of time that must pass before you (the employee) has the ability to exercise the option. How long you plan to stay at the company becomes a consideration.

It’s also important to consider your tax situation and make sure that you minimize the tax consequences of selling stock if you’ve used options to purchase it. One question you might consider: Is the fluctuation in the stock you own likely to be more than your short term vs. long term capital gains rate?

The time value of money is another critical factor. Basically, this is the concept that a dollar in your pocket today is worth more than a dollar in your pocket in one years time. However, it can also mean that options might be worth more in the future if the price of company stock is given time to grow.

Employees risk overexposure to their company stock. It’s important to diversify a single stock holding and to make sure it doesn’t comprise too large a percentage of in investment portfolio. Around 5% and no more than 10% is a guideline I use with clients who want to hold onto company stock. The reason for diversification is two fold. (1) A single stock holding is likely to be more volatile than a diversified portfolio. This can seem good when the stock is beating the general market but can really hurt when it dips below. (2) The employee has double exposure to the company. Not only is it a large part of your net worth, but it is also your job. If the company took a turn for the worse (think Enron) you could suffer on two fronts.

A comprehensive stock options strategy will likely be ongoing as more shares vest and stock is eventually bought and sold. Investopedia has helpful ESO articles that explain everything from Valuation and Pricing Issues to Risk and Rewards Associated with Owning ESOs. Make sure you have a strategy in place to realize the compensation you’ve earned, build your net worth and, of course, continue to SaveUp!

This post was written by SaveUp’s personal finance contributing writer, Catherine Hawley, CFP®.

Image source: Inc.

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Written by Catherine Hawley

Catherine is a CERTIFIED FINANCIAL PLANNER (TM) who offers accessible and objective financial advice to individuals and families. Her aim is to help clients gain clarity and confidence so they can pursue their definition of financial success. You can find more information about her independent practice at www.catherinehawley.com. She has worked at Rhodes & Fletcher, LLC as a Personal Benefits Specialist and at the firms of Bernstein Global Wealth Management and Barclayʼs Global Investors. Catherine has a bachelors degree in communication studies from the University of California, Los Angeles where she was a scholarship athlete and captain of the womenʼs tennis team.