Tuesday, April 29, 2008

The fine print on Stock Options

Stock options are a wonderful thing, but they come with a lot of rules requiring careful management. Here are some of the general rules to keep in mind if you have stock options:

An Option may not be exercised until it has vested. Vesting is all about the rights of ownership. You have no right to the option until it is vested, even though it can still be working for you, appreciating in price, in the market. Typically, stock options will come with a vesting schedule, such as the one below. In this case, one third of the shares will be vested at the first vesting date, then another third at the second date and so on.

First Vesting Date: January 29, 2005 - One-Third
Second Vesting Date: January 29, 2006 - One-Third
Third Vesting Date: January 29, 2007 - One-Third

Some of the caveats for vesting:
* If you die or become disabled, all unvested Options will immediately vest.

* If you resign or otherwise terminate employment, whether voluntarily or not, unvested Options will be forfeited upon your termination. While Vested Options will expire at the end of their remaining term or 30 calendar days following your resignation or termination, whichever is shorter.

If you have early retirement plans, be sure to keep this last warning in mind. You have 30 days after termination to exercise your vested options or lose them!

Once an option is vested, you have the right to exercise it. Exercising a stock option means buying the stock at the price set by the option (grant price), regardless of the stock's price at the time you exercise the option. You must pay the stock option cost (grant price) to your employer and in turn you receive the shares in your brokerage account.

More caveats:
* Options must be exercised within ten years of the grant date.

* Once the option has been exercised, you can sell the stock or hold it as long as you like.

When you sell shares which were received through a stock option transaction you must pay ordinary income tax on the difference between the grant price and the exercise price. In addition, if you hold the shares and they appreciate, you must pay capital gains tax on the difference between the exercise price and the final sales price.

It is possible to reduce this tax bill by holding the stock options at least one year. For instance, if you had waited to sell the stock for more than one year after the stock options were exercised and two years after the grant date, you would pay capital gains, rather than ordinary income, on the difference between grant price and the sale price.

1 comment:

  1. Nice post!
    There's also a big caveat about holding onto the stock once your options are exercised- you are responsible for any price difference gains between the grant price and exercise price regardless of what the stock does in the future, even if it should tank below your grant price.
    It's not such a big deal when the market is firmly in bull territory, but when the market is on the weak side, it's something to take into consideration. There were stories of many folks upside down with their exercised stock options during the dot com crash.