Explain employee stock options to an eight year old

[IDemo]

I've been given some stock options for saving the company some money, but don't really understand them. I think it means that I can buy shares at their current value and sell them later with a guarantee that I will get no less than that price. What does 'exercising' an option mean - is it the purchasing of these stocks during a limited window of time, or the selling of them after a one year (or however long) period? Will Uncle Sam make the whole exercise pointless at tax time if the stock isn't on a rocket-sled upwards?

Yes, they do have some explanatory material on the company site, but it all looks targeted toward people already familiar with these things.

Thanks for any replies. :hi:

[elehhhhna]

1. the option's worth 10 bucks.

WHEN the stock gets way higher than ten, say, it's 20, you have the OPTION to BUY it at 10 and SELL it at 20. Trades have 5 business days to "settle", that means pay up, so in 5 business days the trades (buy at 10, sell at 20) simultanously "settle". You get a check for the difference - in this case, 10. bucks per share. The end.

[IDemo]

5. You're saying the option to to buy/sell becomes open contingent on a gain in the stock price?

[elehhhhna]

25. Well, you could exercise the option and buy the shares anytime BUT

why do that when you have an option which allows you to buy them at that option price anytime? The only reason to buy and hold is IF the option is set to expire (years from nowe - check your paperwork - and you WANT to buy and hold , thinking that the price is high and going higher. It is an option to buy at 10, regardless of whether you plan to hold the shares or sell at a higher price at the same time.

[Hannah Bell]

33. and then you get to pay cap gains tax on the gains at a lesser rate than regular income.

nice scam.

[Onlooker]

2. I had some once.

It means that when you're ready you can buy them at the price they told you. Thus, if your option price is $5/share and they go up to $10/share, you can buy them at $5/share (making a handsome profit). If you're in one of those companies that is growing exponentially, it's worth holding on to them. Also, chances are your company will give you more options with each passing year. Options can become quite valuable, and you'll want to do some research on your company's stock. (If the experts are saying your stock is a good one in the long term, it's worth holding on to your options.) But, be sure to pay attention to the deadline. Options expire at some point. When you buy them, the broker will allow you to use the profit from the options to buy them so that you won't have to lay out any money.

[Very_Boring_Name]

6. So whats to stop you from spending your entire lifes savings buying up 10,000 shares of 5$ stock

and selling it for double that? Is there some limit?

[IDemo]

10. You will generally only be given X number of shares

In my case, 100.

[JoePhilly]

3. Here's my simple attempt ..

Stock options allow you to buy X shares of company stock at a given price, say $100, at anytime between now, and a fixed future date, often 10 years after the date you received them. During that 10 year period, you can buy the company stock for $100 a share regardless of the actual price.

So, let's say 2 years after receiving the X shares, your company stock hits $200 a share. You can BUY as many shares, up to X, as you want, each at $100 a share. If you then IMMEDIATELY sell them for $200, you pocket the $100 difference ($200 current - $100 what you paid = $100 profit).

Usually, that $100 difference that you would pocket will be TAXED as ordinary income. Which means you will actually get to keep only about 63% or so after taxes and fees are paid, and depending on your normal income.

If you don't exercise the options in that 10 year period, they expire and you lose them. They go away.

Also ... if your option price was $100, and your company's stock price stays BELOW $100, the options are often called "under water". That means, they are basically worthless at that time. Why buy a stock at $100 a share via your options, when you could buy that stock at its actual current price $60? This point is important because your OP seems to suggest that you can sell them for the option price and get no less. That's not the case. The option price only describes the price at which you can BUY the stock, not the price you can sell it for later.

Basically, options are worth the difference between the option price, and the current stock price. If the difference is positive, you are "above water", if the difference is negative, you are "underwater".

There are some variations on this. In some forms of stock options, when you BUY the shares, you MUST also sell them at the same time, and take the profit immediately. In some others, you can buy and hold the stock. But that depends on the type of options.

There are some other things to think about, but this is pretty close.

[A HERETIC I AM]

31. In options parlance, it is "In the Money" and Out the Money"...

Not "Above Water" and "Underwater".

If the exercise price is the same as the strike, it is "At the Money".

[JoePhilly]

32. Not where I work, at least not in terms of a simple short hand ...

for quickly describing the state of your options at any given point in time.

Where I work, and actually when I think about it, with others I know who don't work at my company but with whom I've discussed either their option situation, or my own, the short hand has always been "above water" or "under water" (I think "below water" also makes the occasional appearance).

Not that this really matters much, its just a short hand for whether your options currently have any value.

[slackmaster]

4. A cautionary tale about how I got royally screwed over on stock options and almost had to pay AMT

In 1996 I got hired by a start-up company that was creating educational software.

Included in the perks they gave me for signing up early were some stock options. I don't recall the exact details, but let's say I had the option of buying up to 1,200 shares at $1.25 per share. There was no guarantee on what I could sell them for, but there was a stipulation that I could not sell shares until six months after the date I chose to exercise the options.

The stock went public in February 2001. It closed at something like $25 per share on the first day. I exercised my options, costing about $1,500 out of my pocket. I was concerned that the company could be bought out and the options rendered worthless, or that I might be hit with a layoff.

What I did not understand at the time was that for valuation purposes, the IRS would use the market value on the day I exercised the options. So in their eyes I had suddenly become $28,500 wealthier in the form of a capital gain, even though I could not legally sell the stock until August.

Within a few weeks of the IPO, the company's financials began a long, painful slide. Venture capitalists who had invested tens of millions got cold feet. The sales cycle was very slow, as the company's only customers were public school districts. Red ink flowed freely. The dot com bubble that had lifted the company to insane heights had burst.

By the time I was able to sell out, the price was down to about seven cents per share. There was no hope of it ever recovering, and buyout rumors hung heavily in the air. I ditched the stock and received less than 75 (correction) dollars back from the $1,500 that I had invested.

Then came tax day in April 2002. My tax accountant gave some long "Hmmmmmmmms" and a couple of "Uh-os", then started asking me about things that I might be able to deduct. We were able to scrape up some things like non-collectible personal debt and non-reimbursed business expenses.

I ended up forking over about $4,000 out of pocket to the IRS; real tax on money that I never really had. My tax guy stuck to my copy of the return a small Post-It note saying "Missed AMT by $16.06." If I'd been forced to pay AMT, my check to the IRS would have been around $11,000 instead of $4,000. While in reality I'd had a capital loss of almost $1,500, the IRS saw it as a gain of $28,500. By digging deep for deductions I was able to pay ordinary capital gains instead of the dreaded Alternative Minimum Tax.

Be very, very careful with stock options. Make sure you fully understand the rules governing their exercise, what restrictions and obligations they carry, and the tax implications thereof.

[Very_Boring_Name]

7. I know the IRS has a reputation as being pretty cold blooded but

you'd think they'd be a little more understanding about individual circumstances like that.

[slackmaster]

9. AMT was supposed to help keep rich people from getting too rich.

It has a fundamental flaw of not being indexed automatically for inflation. Congress takes up the issue just about every year, and passes a bill to move the thresholds up so as to avoid having AMT hit the middle class.

[Scruffy1]

8. Yes, I've seen the same thing happen

The real problem is that you have no cost basis, since the stock was not freely trading when the options were issued and you did not pay for them. The IRS will treat this as income like wages.

[Stinky The Clown]

11. See . . . when you werk fer someone, you get called an im-PLOY-yee . . . .

. . . . imPLOYyees are imployed. If yer good, they give you options. That means you can OPT to buy stock. Its your OPT. We want you to keep your OPT.

[nomb]

12. Here is everything you need to know:

Here is everything you need to know:


Next day sale. Period. You exercise at the same moment as you sell them out.


It's a win, a profit, a taxable gain, whenever or however you are given money for "free". The profit part is the difference between what you paid as an insider on preferential terms as a vehicle for compensation - and what its true value is, represented by the true transfer of wealth.

If you choose to convert your compensation into a long term investment by retaining the stock, you may. But it is at your own risk. A passive receipt of free money may not intuitively lead to an acceptance of the tax, and subsequent market risk, but it is both logical and reasonable.

An alternative strategy is to sell only that portion necessary to satisfy the tax obligation. But never, ever, leave the IRS's money at risk. Ever.

[slackmaster]

13. It's logical, but reasonable only to the extent that you have immediate control of the money

I got no benefit whatsoever from the option exercise I described in reply #4. I never had any opportunity to realize a benefit, because I had no control over the shares until they had evaporated to nothing.

In my case I would have been better off simply allowing the options to expire, but I had no way of knowing that in advance. I may have received an insider perquisite, but I didn't have the benefit of inside knowledge that might have altered my decision.

[nomb]

14. Some details are missing....

You exercised before they expired, and inside of a lockup. Exercising outside of the lockup would have, and must, allow for an exit. The error was not waiting until you had control to exercise. This is the most likely scenario based upon the few details I've gleamed above.

If the options were exercised pre-public then I fail to see what they used to mark-to-market for valuation.

[slackmaster]

21. Details have faded from my memory

The bottom line is I made a bad decision, painted myself into a corner, and payed thousands of dollars for it.

The error was not waiting until you had control to exercise.

As I recall, there never was such an opportunity. I exercised the options because I thought there was a good chance I'd be able to sell the stock at a substantially higher price than I paid for it. I learned a painful lesson that year.

[IDemo]

15. Thanks, all, for the responses

I think I get the general idea. Another question: it sounds as if the immediate sell of a stock upon exercising the option will make it appear as simple income, so any increase of less than 40% or so in the share will make it a wash, financially. When or how would it become treated differently, tax-wise?

We're talking about a hi-tech company here whose stock is on a roller coaster even during non-crash periods. Things have taken a decided look upwards lately, though, and they have been projected by one source to increase by ~50% by the end of 2011.

[freethought]

17. Here's what I know

You're correct in your thinking, an immediate sell of stock will have you paying a capital gains tax rate of well over 30%. The trick here is to hold on to that stock once you've exercised your option. Capital gains tax rates go down to about 15% or so if you have held the asset for a year or more.

There in lies the trick, you have to "speculate" that the company's stock will be at a market value at more than a year out. This is not always easy. It's best if you look at the company's financial fundamentals like, how much cash is in the bank, how much debt are they carrying, what has been the pattern for sales these last few quarters, etc...

[nomb]

18. It depends...

You need to know if you're in a qualified plan, or nonqualified. If the money can potentially change your standard of living - hire a tax attorney to set up how, when and into, which entity will do the transaction.

If you're just getting enough to buy a new BMW, don't sweat it. Go see a couple of pro's, at the bank, your HR (a potentially great resource), the broker, or a reputable tax guy with experiance in this area - then Exercise, sell all or just what's needed to pay the tax and then put the proceeds where you'd like.

Congratulations, there are worse things to stress you out. :)

[Statistical]

19. The amount of the excerise is regular income. Any gain past that is a capital gain.

All stock options always have three elements.
a) numher of shares
b) target price
c) expiration date
d) (optional) lockup date

Know those 3 or 4 elements.

An example:
You have an option for 100 shares of xyz corp @ $10 per share which expires December 2020. There is no lockup.

Say stock is trading at $150 per share. You exercise the option which means you pay $1000 ($10 target * 100 shares) to acquire 100 shares of xyz corp.

If you sell immediately. You would see $5,000 profit and it would be taxed as regular income by IRS (($150 - $100) * 100 ).

Now lets say you don't sell and stock then continues to climb to $180 per share and which point you sell.
There still is $5,000 regular income plus another $30 per share or $3,000 as capital gain. The rate the cap gain is taxed depends on how long you held the shares.

[nomb]

A bit more complicated than that, quite a bit actually

Here's a primer on the basic program: http://en.wikipedia.org/wiki/Incentive_stock_option


As to what drives the passing of the tax burden, deferred vesting, options pricing (rho, theta, vega,...), technical analysis of price, momentum, mean reversion, fade, and fundamental analysis ... well, let's just say:


Next day sale. :)

[Statistical]

27. I was thinking more like NSO.

http://en.wikipedia.org/wiki/Non-qualified_stock_options

Personally have never been lucky enough to receive the more preferred ISO.

Maybe OP should clarify if it is an ISO or NSO.

[nomb]

20. Just to underline qualified/nonqualified ISOs

Just to underline, if it's a qualified plan you can "next day sale" and pay capital gains and not be taxed at the higher ordinary income rate.

You most likely have an ISO.

[JoePhilly]

34. I've been through something like this in thepast ...

You may want to think NOW about a upper price at which, if reached, you would exercise SOME options.
Similarly, you might also set a floor, a lower price at which, if reached, you would exercise SOME options.

As long as the options STAY in that range, you don't need to do anything. If they break out in either direction, you exercise SOME.

Immediately after this exercise, you RESET your upper and lower boundaries.

In some cases you can set this up to be automatically.

I prefer to set such ranges and then if my options approach them, I get very serious about whether I should exercise some, determine how many, and figure out tax implications. To this, I then consider current market dynamics, whether my company is up or down for what I think are "real reasons" (sometimes one company has a bad quarter and lots of other tech stock drop for now reason, and so they usually come back, but not always, so you have to think about it). Then I decide.

[freethought]

16. There's good advice here

As you have described it you have been given the right to buy shares of stock at a specific price with in certain period of time. Options are speculative in nature, so as some posters have said they are tricky. If you guess right on the value of a stock you make some cash. Guess wrong, and you can loose your shirt, and that could be putting it mildly.
The time window for exercising an option can bee anywhere from days to even years. Most big-time CEOs are given options that last for a decade or even more. I would hope your employer granted you options for a good long window of time.
As for what you will pay Uncle Sam, it depends on a few things. With capital gains like the buying/selling of stocks a great deal depends on when you exercised the option and when you sold the stock. If you exercised the option and bought some stock and immediately turned it around and sold it, you are going to pay a higher capital gains tax rate. I don't recall the exact rate but I do believe it to be at or above a 30% rate. If you exercised the option and held the stock for over 1 year then sold it, capital gains tax rate goes down, I believe to at or around 15%. This is one way the government tries to encourage more long-term investing, you get a lower tax rate on investments that have been held long term.

The stock does not necessarily have to be on some rocket path upward but a definite upward trend is certainly what you want. This is where so much of this gets tricky. You could exercise your option and sell the stock when it's at some high peak all in the same day, but you will pay more in taxes. You could also exercise your option and hold the stock you own for a while then sell it for a lower tax rate. You could also exercise your option and watch the stock value fall like a rock. You could even exercise your option, sell the stock at a nice profit, then watch the stock value go up even more after you've sold it. There are risks and there are trade-offs.

[Statistical]

23. One clarification. Exercised NSO stock options are always treated as regular ciome

Example:

You have an employee stock option with target price of $100. The stock is trading at $150. You excercise it. The difference $50 ($150-$100) times the number of shares will ALWAYS be treated as regular income (wages) and not capital gains.

If you hold the stock less than a year and it has a gain (or loss) any movement from $150 will be taxed as short term capital gains.
If you hold the stock more than a year and it has a gain (or loss) any movement from $150 will be taxed as long term capital gains.

In either case the regular income still applies. Example you hold the above stock till it reaches $180 and sell.
For each share you will see:
$30 capital gain ($180 - $150)
$50 regular income ($150 - $100)

[IDemo]

24. Thank you, freethought, for your replies

Though trying to second guess where this stock or the market in general will be after a year seems to be the domain of soothsayers, I'm feeling pretty good about the prospects.

[mdmc]

22. I have the option to purchase nike employee stock

basically I can buy class b stock and sell it - buy low sell high..

[bluestate10]

26. You can buy the stock at a set price (the strike price of the option).

Or you can sell the options on the open market if they are worth money. Say, you got an option to buy 1000 shares of your company's stock at $7 per share with the options 100% vesting in two years. After two years, if the stock is $7, you have no profit but can either cough up $7,000 to buy the stock outright, or take your chances and hold the options until the expiration date for them under the hope that they will be worth something before they expire. But, say you get the 1000 options at $7 strike and once the vest in two years, the stock price is $18, you can sell the options for a profit of $11 per share, grossing $11,000, and you don't have to buy the stock to make the profit, typically the brokerage that buys you options will but the stock, or retire the options.

[bluestate10]

28. I know what stock options are, but I would rather determine the economic

benefit of your savings idea and give you money outright as a bonus. My view on the stock market is not a good one, my view is that stock ownership is at the base of the outsourcing craze that is costing jobs and creating societal angst.

[nomb]

29. Consider this.

The only thing that drives your decision to exercise is whether it's profitable to do so. Easy enough. Whether the tax man takes some or most of the profit doesn't come into play here.

Having exercised, you now have to pay the tax. Do so immediately. Now you'll have no tax stress. Easy enough.

Now you can decide what to do with the rest of the stock, sell it or hold it. Speculate, blow it in Vegas, burn it, whatever you want. This is unrelated to your original exercise - it just feels connected because we aren't dispassionate about the math as human beings, we tend to personalize and attach emotionally to money.

It's a number of different finite decisions that are made at any time - and executed sequentially.

But the one decision, to exercise, is driven only by the fact that someone will pay you a number greater than X, with X being the price you pay at that moment.

[WinkyDink]

30. Here's how: "Hope your company doesn't tank like Bethlehem Steel, kiddo!"