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The Basics of Stock Options

January 7, 2001
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Related Topics: Compensation Design and Communication, Featured Article
Human resource and compensation and benefits professionals are faced withnumerous questions from employees and executives on stock options. We asked theeditors at for a sampleof their Q&A's on a range of stock compensation questions that you mightreceive - or ask yourself.
  1. What is a "stockoption"?
  2. Why docompanies grant stock options?
  3. Why should I care about stockoptions?
  4. How can Ifind out if my employer offers stock options?
  5. Are there employers who cannotoffer stock options to their employees?
  6. What are the important documentsI need to understand a stock option plan?
  7. Are there different types ofstock options offered by employers?
  8. What is a "nonqualified stockoption"?
  9. What is an"incentive stock option"?
  10. How will I know which type ofoption I have been granted?
  11. Can I be granted bothincentive stock options and nonqualified stock options?
  12. Is it better to be grantednonqualified stock options (NQSOs) or incentive stock options (ISOs)?
  13. What other types of equitycompensation plans are offered by employers?
  14. What is "restricted stock"?
  15. What is an "SAR"?
  16. What is an"employee stock purchase plan"?
  17. What is a "phantom stockplan"?
  18. What is an"employee stock ownership plan"?
  19. What is a "vesting schedule"?
  20. Are there anylimitations on when I can exercise my options?
  21. I am cash poor. Will I stillbe able to take advantage of my company's stock options?
  22. Do stock options ever expire?
  23. What are"underwater" stock options? What might my company do about it?
  24. What is a "stock split"?
  25. How does a stocksplit affect my option grants?

1. What is a "stock option"?

Generally speaking, a stock option is a right granted by a corporation to anindividual to purchase a specific number of shares of stock of the corporationat a pre-determined price during a specified period of time.

For example, you could receive a grant of 1,000 options, with an exerciseequal to the market price on the date of grant, with ten years in which toexercise your options to obtain ownership of the 1,000 shares of stock.

2. Why do companies grant stock options?

Companies grant stock options for a variety of reasons. The most commonreasons are:

(i) to attract and retain valuable employees
(ii) to motivate employeesto work harder to increase the value of the company and its stock price
(iii) to align the interests of employees with those of shareholders andcreate an ownership culture
(iv) to avoid the payment of cash compensation.

Furthermore, it should be noted that in most cases, stock option programs(unlike cash compensation) do not result in any compensation expense forfinancial accounting purposes, which can reduce a company's earnings.

3. Why should I care about stock options?

Stock options allow employees and other service providers to share in thefuture growth of the value of a company without risking their money until theyexercise the options to buy the shares. In many instances, the gain on a stockoption may be substantially greater than one's annual compensation. In addition,cash bonuses and most other forms of compensation are taxable when you receivethem. Stock options, on the other hand, are not taxed at grant; rather, you paytaxes only when you exercise the options and/or sell the underlying stock. Insome cases, stock options can provide favorable long-term capital gains taxtreatment.

4. How can I find out if my employer offers stockoptions?

If your employer is a publicly traded company (e.g., its shares are traded ona stock exchange such as NYSE or NASDAQ), your employer is required to filevarious reports with the Securities and Exchange Commission. Among the documentsthat are filed with the SEC are the company's stock option plans. Note that yourcompany may have more than one plan in effect at any time. You can find adiscussion of its stock plans in the company's proxy statement and Form 10-K,both of which are filed electronically with the SEC using a system called EDGAR(electronic data gathering and retrieval). See and other commercial Websites for access to the filings. The proxy statement is Form DEF-14A or DEF 14-Con EDGAR.

The simplest way to obtain a copy of your company's stock option plans --particularly if you are potentially eligible for a plan -- is to ask your humanresources or benefits department for a copy of the plan documents. They mightalready be available on your company's intranet or benefits Web site.

5. Are there employers who cannot offer stock options to theiremployees?

Typically, only for-profit corporations are eligible to offer stock options,although limited liability companies have developed innovative ways to grant theequivalent of stock options. Government entities, churches, non-profits (such ashospitals or schools), mutual insurance companies, professional corporations(e.g., doctors, lawyers), and sole proprietorships do not offer stock optionseither because the entity is prohibited from doing so by law, or because theentity is not owned by shareholders.

6. What are the important documents I need to understand astock option plan?

You should look at the stock option plan, the grant agreement, and any othercommunication materials your company gives you or posts on its Web site, such asa summary booklet or FAQs. Other important documents are the stock optionexercise notice and, for plans of public companies, the "prospectus." See theGlossary andFAQ sections of for more information on these stockplan documents.

7. Are there different types of stock options offered byemployers?

Yes. Most employers offer "nonqualified stock options" (NQSOs) to theiremployees. Some employers, particularly technology companies and start-ups,offer "incentive stock options" (ISOs). These two types of stock options derivetheir names from their tax status under the U.S. Internal Revenue Code.

8. What is a "nonqualified stock option"?

A nonqualified stock option, or "NQSO," is a type of stock option that doesnot qualify for special tax treatment under the U.S. Internal Revenue Code. Itis the most common form of stock option and may be granted to employees,officers, directors, consultants, and other providers of goods and services.Companies have great flexibility in setting the exercise price and most otherterms of an NQSO. Subject to shareholder tolerance for dilution of theirownership percentages, there are no limits on the number of NQSOs that may beauthorized under a stock option plan.

Nonqualified stock options result in ordinary income to the option holder atthe time the option is exercised, to the extent the market value of the stockexceeds the exercise price. The company receives a corresponding tax deductionas long as it reports the optionee's income to the IRS. More details appear's FAQson "NQSOs: Basics & Taxes."

9. What is an "incentive stock option"?

An "incentive stock option" or "ISO" is a type of stock option that qualifiesfor special tax treatment under the Internal Revenue Code because it meetscertain conditions set forth in the Code.

ISOs are not granted by all companies and can only be granted to employees.There is a $100,000 limit on the aggregate grant value of ISOs that may firstbecome exercisable (i.e., vest) in any one calendar year. Also, ISOs mustgenerally be exercised within 3 months of termination of employment.

If the stock acquired upon exercise is held for at least two years from thedate of grant and one year from the date of exercise, then the employee receivesfavorable long-term capital gains tax treatment for all appreciation over theexercise price. Don't overlook the significant impact that ISO exercises andsales may have upon alternative minimum tax (AMT) calculations. More detailsappear in's FAQson "ISOs: Basics & Taxes."

10. How will I know which type of option I have beengranted?

Look at your grant agreement. It will clearly state whether the grant is anonqualified stock option or an incentive stock option. (If the grant agreementis not clear on this point, check with the person at your company responsiblefor administering the stock option plan.)

11. Can I be granted both incentive stock options andnonqualified stock options?

Absolutely, as long as your company's stock option plan permits both to begranted. In many instances, large grants to employees are divided into twocomponents. First, the company grants ISOs to the employee up to the maximumallowed by law for ISOs (no more than $100,000 of grant value can be firstexercisable in any calendar year). The balance of options are then granted asNQSOs.

12. Is it better to be granted nonqualified stock options(NQSOs) or incentive stock options (ISOs)?

First, you may only be eligible to receive NQSOs, so check the earlier FAQ onthe specific requirements. As for which is better, it depends on what you dowith the shares you acquire at exercise. If you immediately sell them, then thetaxation is essentially the same, although there is no tax withholding withISOs. If you plan to hold them, then some tax benefits exist with ISOs. Theyprovide you with the potential for favorable long-term capital gains taxtreatment on all of the post-grant stock price appreciation, should you hold theshares for one year after exercise and two years after grant.

But, if the stock price of a company's shares underlying an ISO appreciatessignificantly before (rather than after) exercise, an ISO exercise can generatea significant alternative minimum tax liability. To pay that liability, anemployee may be forced to sell some of his or her shares in a so-called"disqualifying disposition" of the ISO shares. This gives rise to ordinaryincome in much the same way that the exercise of a nonqualified stock optionwould, although ordinary income taxes are not withheld by the company.

If a disqualifying disposition of an ISO does occur, the sale of the ISOshares would not give rise to wages for social security tax purposes as wouldthe exercise of a NQSO. This result is a quirk in the law which ends up savingyou and your employer at least the Medicare portion of the Social Security taxon the spread at exercise of an ISO of 1.45% each.

Also note that ISOs require you to plan for possible significant alternativeminimum tax (AMT) consequences.

13. What other types of equity compensation plans are offeredby employers?

For a variety of reasons, including tax treatment and compensation policy,some employers provide other forms of equity-based incentives in addition to orinstead of stock options. These arrangements include restricted stock, phantomstock, stock appreciation rights, employee stock purchase plans (ESPPs) andemployee stock ownership plans (ESOPs).

14. What is "restricted stock"?

Restricted stock refers to outright grants of company stock to employees orother service providers. Restricted stock is usually granted only to keyemployees and executives of a company. The stock is "restricted" in the sensethat it is subject to a vesting schedule, which can be time- orperformance-based, and other limitations on transferability or sale that thecompany might impose.

15. What is an "SAR"?

An SAR, or "stock appreciation right," is a contractual right granted by anemployer that entitles an employee to receive the appreciation in value onshares of employer stock. Instead of exercising a stock option, the employeeexercises the SAR and receives in either cash or stock the "spread" between theexercise price and the fair market value on the date of exercise. Typically,SARs are used by companies which, for policy or securities law reasons, do notwish to grant options to employees to purchase actual shares in the company.While SARs produce tax deductions for employers, they are less desirable thanstock options from the employer's perspective because they also produce acompensation expense for financial accounting purposes.

16. What is an "employee stock purchase plan"?

An employee stock purchase plan, or "ESPP," is a broad-based arrangementsponsored by a public company under which substantially all of the company'semployees are permitted to purchase stock at regular intervals, often at adiscounted purchase price. More details about ESPPs are explained in FAQsection devoted to them.

17. What is a "phantom stock plan"?

A phantom stock plan is similar to an SAR, as described above, in that therecipient receives a sum based on the appreciated value of the company's shares.But, instead of shares of stock, phantom stock awards are in the form of stock"units," the value of which is equivalent to the company's common stock. Theseawards are always settled in cash and are taxable to the recipient as ordinaryincome when paid. As with SARs, phantom stock plans are used by employers who donot wish to or who are prohibited by law from issuing shares to employees. Theyare more common in private companies that do not expect to go public. Phantomstock plans produce unfavorable financial accounting charges to companies whencompared to stock options.

18. What is an "employee stock ownership plan"?

An employee stock ownership plan, or "ESOP," is a tax-qualified retirementplan designed to invest primarily in voting stock of the employer. As aretirement plan, the contribution of cash (which is used to buy company stock)or company stock to the plan is immediately deductible (subject to certainlimits) by the employer. The employees do not pay taxes on amounts receiveduntil plan benefits are actually paid, usually at termination of employment orlater. In some instances, the participants who receive distributions in the formof stock may defer taxation of the appreciation on the stock. To satisfy the taxrules of retirement plans, ESOPs must cover a broad range of employees, adhereto vesting schedules no less favorable than provided by law, and allocatebenefits on a substantially uniform basis (e.g., as a percentage of W-2compensation for the year). ESOPs are used principally by entities with regularcash flow that need tax deductions.

19. What is a "vesting schedule"?

A vesting schedule determines when you may exercise your stock options orwhen the restrictions lapse. A vesting schedule is time-based if you must workfor a certain period of time before you get the benefit. The schedule could alsoor instead be performance-based or link to company-specific or stock markettargets. Vesting in some situations can be accelerated by the board of directorsor upon certain events, such as a merger.

20. Are there any limitations on when I can exercise myoptions?

You cannot exercise your options unless they are vested. The one exceptionwould be an option plan (typically, of a private company) which allowsoptionholders to exercise immediately into stock, subject to a companyrepurchase right similar to the restrictions in a vesting schedule. Also, youcannot exercise options that have expired by their terms with the passage oftime. In addition, your right to exercise vested options after your terminationof employment will be limited as provided in your company's option plan or yourgrant agreement. This period may expire as soon as your last day of work.Finally, you may be restricted by company policy from exercising duringso-called "black-out periods."

21. I am cash poor. Will I still be able to take advantage ofmy company's stock options?

Yes. Many companies have procedures that allow for cashless exercises, whichare a way for you to take out the profit between the market and exercise pricewithout having to come up with the cash to buy the shares. The FAQsection on "Exercise" at explains this in more detail.

22. Do stock options ever expire?

Yes. Most options are granted with a ten-year term. Some have a shorter life,such as five years. If you have been employed by the same company for many yearsand were granted options many years ago, you should check the term of the optionas set forth in your grant agreement. You can use the MyRecordsfeature at to keep track of your options and their expirationdates. If the expiration date is not clear, ask the company for clarification inwriting and for any additional rules that apply when you leave the company.

Keep in mind that if you leave the company, you likely will not have thebalance of the term to exercise your options. Instead, you have the shorter ofthe balance of the option term or the length of the post-termination exerciseperiod. The post-termination exercise period is a very short window -- typicallyfrom your last day of work to, say, 90 days -- to decide whether or not toexercise your stock options.

23. What are "underwater" stock options? What might my companydo about it?

Your options are underwater when the exercise price is greater than themarket price of the stock. For example, you may have options with an exerciseprice of $10 per shares, while the stock is trading at $8 per share. While verycommon just a few years ago, few companies today reprice their outstandingunderwater options because of the negative feelings about this by institutionalinvestors and the adverse accounting treatment. Repricing essentially givesoutstanding options a new exercise price at the lower current market price.

24. What is a "stock split"?

A stock split occurs when a company wishes to lower its share price to permitmore investors to be able to purchase its shares. When the company declares astock split, each shareholder receives more shares in the company, but with alower per share price, so that each shareholder's investment value remains thesame.

For example, if you own 5,000 shares that are trading at $100 per share andthe company announces a 2-for-1 stock split, you would ultimately own 10,000shares, which would initially trade at $50 per share. Your investment value of$500,000 wouldn't change.

25. How does a stock split affect my option grants?

Under your company's stock option plan, your options will be automaticallyadjusted for the stock split. Your number of options will be adjusted upwards,and your exercise price downwards.

For example, assume that you had 3,000 options to purchase company shares at$30 each. If your company's stock split 3-for-1, your options wouldautomatically be increased to 9,000 and your exercise price decreased to $10 pershare. The total amount you must pay to exercise your entire option grant wouldremain unchanged (here, $9,000).

These FAQs provided by

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