When an exciting new job offer comes in, you may suddenly be faced with making decisions around some pretty complex compensation package options. It’s important to have the tools you need to negotiate your best offer.
Packages that include equity compensation instruments like “employee stock options” can be a little daunting to navigate. Knowing how they function, their benefits and risks, and where to get the best advice are key to securing an offer that aligns with your financial goals and expectations.
Getting Started with Employee Stock Options
What are Employee Stock Options?
Employee stock options (ESOs) are a unique form of equity compensation granted by your employer, giving you the exclusive right to purchase shares of your company’s stock at a predetermined price within a specified timeframe.
What are some benefits and risks to ESOs?
Some stock options can offer tax benefits, and in some cases, employees may be able to defer taxes until they sell their stock.
ESOs also entail specific and significant risks that can lead to loss of the stock’s value or total forfeiture of the stock.
How do I get the most out of my ESOs?
Consulting with your financial advisor provides you with valuable insights and strategies tailored to your specific circumstances to help you mitigate risks and get the most out of employee stock options.
In this article, we’ll give you a simple working definition of employee stock options, discuss why companies offer them, and what benefits they bring to you as an employee. We’ll also expose some of the risks involved so you can approach them with confidence. Whether this is your first experience with employee stock options or you’re seeking to enhance your knowledge, this article is your friendly guide to unlocking the potential of these valuable tools to help you build long-term financial success.
What Are Employee Stock Options?
Employee stock options (ESOs) are a type of equity compensation offered to you by your employer. Simply put, ESOs allow you to buy shares of your company’s stock at a fixed price, but only for a certain period of time. Owning company stock can be a smart move for your finances so long as you have a fair understanding of the ins and outs.
Benefits of Employee Stock Options
ESO’s are often used to attract top talent and keep valuable team members on board. Basically, you can participate in the growth of the company when the stock increases in value. Some ESOs can even give you a break on taxes, and often, you can hold off on paying those taxes until you decide to sell your stock. Adding ESOs into your financial plan can help you build a well-rounded investment portfolio.
ESOs have their own unique set of rules which determine when you can use them and how long they’re valid. Plus, there are tax-related matters to think about. All the nitty-gritty details about your specific ESO offer will be spelled out in the official agreement you have with your employer.
Types Of Employee Stock Options
Broadly speaking, there are two types of ESOs which could be offered to you depending on your role and the nature of your employment agreement.
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- Non-qualified stock option (NSO or NQSO): These are a type of stock option that can be granted to employees, consultants, contractors, and other individuals. NSOs do not qualify for the more favorable tax treatment available to incentive stock options (ISOs).
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- Incentive stock option (ISO): An ISO has certain tax advantages over NSOs – you don’t have to report income when you receive the stock option or when you exercise the option, though you may be subject to the alternative minimum tax (AMT). You only have to report taxable capital gains income when you sell the stock as long as certain holding periods are met.
4 Risks Associated with Employee Stock Options
Employee stock options present you opportunities to profit from your company’s stock, but they are not totally secure investment instruments. ESOs entail specific and significant risks that can lead to loss of the stock’s value or total forfeiture of the stock.
- Expiration Risk: If you let options expire without exercising them, you forfeit the opportunity to purchase shares at the predetermined price. This can lead to significant financial losses when options expire. If you want to make sure you don’t forfeit a potentially lucrative investment opportunity, we recommend establishing a series of periodic reviews of your options. You can also set reminders to review them at certain intervals or once your company stock hits a certain price.
- Concentration Risk: While it feels great to watch your company stock, which you own a lot of, continue to go up, it’s vital to think about the downside exposure as well. How detrimental would it be to your personal finances if the company stock went down 20, 30, or 40%? While it may seem unlikely during the good times, we have seen enough companies’ fortunes turn quickly that we know to plan for it. Systematically selling off some of your company stock and reinvesting into other companies reduces your reliance on one specific company.
- Underwater Options: Your company’s stock price isn’t guaranteed to go up, of course. In fact, you could find yourself with options that are “underwater,” meaning the price that you have the option to buy at is more expensive than what the prevailing share price is. In this instance, the options are worthless to you and you would not exercise.
- Ownership Bias: While we’re talking about being financially invested in your employer, it’s important to not overlook the fact that it’s very easy to become emotionally invested in the company as well. When you’re seeing progress inside the company, the initiatives that you’re working towards, and the hard-working people by your side, it’s easy to become optimistic about owning the company as an investment. However, the positive things you are seeing may not be what Wall St. cares about and they may not translate to a booming stock price. It’s human nature to come up against the “endowment effect,” which is the tendency for us to overvalue something simply for the fact that we already own it. While dealing with money can quickly become emotional, tying your investments back to a financial plan will aid in keeping a cool head.
Additional Guidelines to Maximize Employee Stock Option Value
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- Distinguishing between “non-qualified stock options” (NSOs) and “incentive stock options” (ISOs) is crucial due to their differing tax treatments, a vital consideration for financial and income tax planning.
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- Before exercising stock options, gain a thorough understanding of your company’s income tax withholding policies to avoid unexpected tax liabilities.
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- Explore the forfeiture value of unexercised options as they can enhance compensation packages during job transitions, offering valuable negotiation leverage.
Where to Seek Guidance About Employee Stock Options
If you want to dive deeper into understanding and making the most of your employee stock options, it’s a smart move to chat with professionals who know their stuff. We suggest reaching out to your trusted tax preparer or financial advisor. These experts have a wealth of experience when it comes to handling complex compensation, and they can offer you personalized insights and strategies based on your unique situation.
Conclusion
Employee stock options, despite their risks, can be a real boost to your overall financial worth. Even though they might seem a bit complex, it’s worth getting into the details. Always remember to connect your investment choices with your broader financial goals. These stock options you’re getting can be a substantial way to benefit from the growth of your company’s stock.
The financial advisors at SK Wealth are committed to empowering you through informed decision-making about employee stock options and how they affect the other facets of your financial picture. Our financial planning process, The Integrated Financial Advantage™, has been crafted and honed over the past 25 years to ensure our clients receive personalized recommendations that allow them to live with intention, tomorrow and today.
