Receiving employee stock options (ESOs) can feel like a major perk, but how do they fit into your long-term wealth-building strategy? While ESOs offer the potential for significant financial gain, their actual value depends on factors like market performance, timing, and tax implications.
For high-net-worth individuals, making the right decisions around stock options can mean the difference between maximizing returns and leaving money on the table. This guide will explore how ESOs work, their financial impact, and strategies to help you make strategic choices to build wealth. Let’s get started.
What Are Employee Stock Options (ESOs)?
ESOs are types of equity compensation a company gives to employees and executives. You can purchase company shares at a fixed exercise price within a specified period.
Unlike receiving stock directly (as with restricted stock units or RSOs), you must choose when to buy in with ESOs. Should the stock price rise above the set price, you can purchase shares at a discount and sell for a profit or hold for potential future gains. ESOs are a way for companies to reward you and align your success with the company’s growth.
Companies offer ESOs to motivate employees and keep them invested in the company’s success. Ultimately, they give you a reason to stay longer since, over time, stock options can become more valuable. ESOs also align employee interests with company growth—you benefit financially when the company performs well.
How Employee Stock Options Work
ESOs are a valuable part of many compensation packages, enabling you to buy company stock at a predetermined price. Here’s a closer look at the typical ESO process:
1. Granting of stock options
When companies issue ESOs, the exercise price is set at the grant date and is typically equal to or close to the stock’s fair market value. However, for private companies, determining the fair market value often requires an independent valuation through a 409A valuation.
When stocks rise above the exercise price, your ESOs gain value because then you can purchase shares that cost lower than the current market price. However, if the stock price is below the exercise price, the options hold no intrinsic value and are typically not worth exercising.
2. Vesting period
Note that you can’t buy shares immediately after being granted ESO. Vesting is the waiting period before you can use your stock options. It can be based on time or performance goals. This process encourages you to stay with the company and contribute to its success. Once vested, you can now exercise your options.
3. Exercising the options
After vesting, employees have a limited window to exercise their options, usually within 10 years. Exercising means buying the stock at a typically lower price than what the current market offers.
Timing can significantly impact ESOs’ value. Market trends, company performance, and tax implications all play a role in deciding the best time to use your options.
4. Selling the shares
Once you exercise your options, you can sell the shares immediately for a profit or hold them to benefit from future price increases. You can sell your shares through brokerage accounts that keep track of market conditions to gain the best result possible.
Imagine joining a promising startup, and as part of your compensation package, you receive 1,000 stock options at an exercise price of $50 per share. At first, they may not mean much—you can’t use them yet because they need to vest over a couple of years. In this scenario, let’s say it’s four years. Each year, 250 options vest, giving you the right to buy those shares at $50, no matter the market price.
Fast forward to four years—the company thrives, and the stock price is now worth $80 per share. You decide it’s time to exercise your options. You buy all 1,000 shares at $50 each, spending $50,000. In an instant, you have $80,000 on the market—and a $30,000 in paper profit.
Now, you have a choice: sell immediately and cash in your gains, or hold onto the shares until the price climbs even higher. If you sell, you’ll need to factor in taxes on the profit. If you hold on to it, you take on the risk of lower stock price, but you might also see even bigger gains in the future.
12 Key ESO Terms You Need to Know
ESOs involve various terms that can initially be confusing. Ideally, you familiarize yourself with these terms to help you confidently navigate your ESO plan and maximize its potential benefits.
- Cliff vesting – You typically wait one (1) year before any of their options vest. After this period, a large portion or all of the options become available.
- Exercise period – This duration refers to when you can buy stock options after they vest. Some employees delay exercising until an exit event—like an IPO or acquisition—to maximize gains.
- Exercise price (Strike price) – It’s the fixed price at which you can buy company stock once your options vest.
- Expiration date – This is your deadline for exercising stock options, typically 10 years from the grant date.
- Exit event – A company sale, acquisition, or IPO lets you cash out your stock options.
- Grant date – During this period, employees are officially offered stock options and gain the right to purchase them.
- In-the-money options – When the company’s stock price exceeds the exercise price, your stock options become more valuable.
- Lapse – This is when you don’t exercise your stock options before the expiration date or if you leave the company before they vest. Your options become invalid.
- Offer letter – This document outlines the details of stock options, including the number of shares, vesting conditions, and the exercise price.
- Option – A right (but not an obligation) to buy company stock at a fixed price. It only has value if the stock price rises above the exercise price.
- Vesting – The process of earning stock options over time. You can only exercise your options once they have vested.
- Vesting schedule – This is the time that determines when your stock options become exercisable. It’s often structured as either cliff or graded vesting.
Benefits and Risks of Employee Stock Options
ESOs can be a great way to build wealth, but they also come with risks. Knowing the advantages and downsides can help you decide when to use them and how to fit them into your financial plan.
Benefits
Wealth potential
Your ESOs could be worth more than what you paid if your company’s stock price rises. This can be a great way to build long-term financial security. For businesses, offering ESOs means employees have skin in the game, which can drive performance upward.
No upfront cost
ESOs don’t require upfront payment. You only invest when you choose to exercise your options. You can benefit from the potential of stock price growth, and your company retains talent without immediate financial costs.
Growth potential
Most ESOs follow a vesting schedule, meaning you earn the right to buy shares over a specific period. This encourages employees to stay longer, and businesses benefit from a more committed team.
Flexibility
Favorable market conditions and personal circumstances should encourage you to exercise your stock options.
Risks
Stock price volatility
ESOs can have an uncertain nature, especially since market fluctuations are unpredictable. If the stock price is lower than the exercise price, your ESOs may not deliver much value.
Lack of diversification
If you hold too much company stock, your financial security might be at risk. If the company underperforms, your investments could lose value. Try to spread your assets across multiple investments for better protection.
Tax implications
Exercising and selling your stock options can affect how much tax you owe. If you’re not careful, this could result in an unexpected tax bill, so be prepared.
Liquidity issues
ESOs only become valuable once you exercise and sell them, but that may not happen until a major event like an IPO or acquisition. It might take years, and the stock price could fluctuate in the meantime. There’s no guarantee that you’ll profit when you finally sell.
Potential for dilution
The granting of more options increases your total number of shares, which can reduce their value. This is known as dilution. While you may get more options, they could be less valuable if more shares are circulated.
How to Make ESOs Work for You
The following steps can be your guide in leveraging ESOs.
1. Understand the tax treatment of your stock options
Know the difference between ISOs and NSOs. ISOs offer tax advantages because they’re taxed lower at a long-term capital gains rate, but only if you meet certain conditions. On the other hand, NSOs are taxed as regular income when you exercise them, meaning you’ll pay higher taxes upfront.
2. Identify when you’ll owe taxes on your stock options
For NSOs, you pay taxes—based on the difference between the strike and the current stock price—when you exercise them. On the other hand, you only pay taxes when you sell the stock with ISOs and might pay a lower rate if you meet certain holding period requirements.
3. Avoid common tax mistakes that can cost you
Before exercising your options, plan for taxes so you avoid surprises. Selling too early could result in higher taxes. If you have ISOs, be cautious of alternative minimum tax (AMT), which may apply if you hold too long. Timing and preparation can help minimize your tax liability.
4. Choose the right time to exercise your stock options
Exercise your stock options by comparing the current and exercise prices. Think about your financial needs—do you need to access the money now, or can you wait? Also, factor in your company’s performance and the tax implications. Timing your exercise can help you make the most of your options.
5. Pick the best exercise strategy for your goals
If you choose early exercise, you can act before your options fully vest, but it comes with risks. You’ll also need to choose whether to keep or sell the shares immediately. Another option is cashless exercise or sell-to-cover, where you sell enough shares to cover the cost of exercising.
6. Diversify your investments to reduce risk
To reduce risk, don’t put all your eggs in one basket. Spread them in different areas like bonds, stocks, or real estate. If your employer’s stock doesn’t perform well, you still have other options to fall back on.
7. Use ESOs to strengthen your retirement plan
Think of ESOs as a way to help fund your retirement. You can convert those gains into long-term savings when your stock options grow. Retirement accounts like IRAs can help your money grow without being taxed excessively. Just make sure your ESO plans line up with your retirement goals.
8. Integrate ESOs into your estate planning
Consider using trusts or gifting strategies to make this process smoother and more tax-efficient. This ensures that your family’s financial future is protected.
9. Work with a financial advisor to maximize ESO benefits
Navigating ESOs can be tricky because it involves significant risks, so having a solid strategy is essential. A financial advisor can help you with tax-efficient strategies, optimize your ESO portfolio for long-term security, and ensure compliance with regulations. They’ll also evaluate how your ESOs fit into your broader wealth-building plan.
If you need personalized ESO advice to secure your financial future, Tencap’s financial planning services fit the bill.
Turn Stock Options Into Smart Wealth Moves
Maximizing the value of employee stock options requires a balance of correctly timing the market and integrating them into a plan that works for you. With the proper guidance, you can turn ESOs into a tool that boosts your financial future while minimizing risks.
Working with a financial advisor guides you to make tax-efficient decisions that ensure the fruition of your long-term goals. The corresponding service fees are an investment whose value far outweighs the cost. Explore our services today at Tencap Wealth Coaching!
Disclaimer: The information contained herein should in no way be construed or interpreted as a solicitation to sell or offer to sell advisory services to any residents of any State other than the State of Utah or where otherwise legally permitted. All content is for information purposes only. It is not intended to provide any tax or legal advice or provide the basis for any financial decisions. Nor is it intended to be a projection of current or future performance or indication of future results. Moreover, this material has been derived from sources believed to be reliable but is not guaranteed as to accuracy and completeness and does not purport to be a complete analysis of the materials discussed. Purchases are subject to suitability. This requires a review of an investor’s objective, risk tolerance, and time horizons. Investing always involves risk and possible loss of capital.
Nick Carrigan
Nick trains and develops families in creating, maintaining, and growing wealth. This includes educating clients on the science and academics of investing, comprehensive financial planning, and ongoing coaching to ensure discipline for a lifetime. Nick has seen this create incredible levels of freedom, fulfillment, and love for the families he works with.
