Stock option program

Common Types

Incentive Stock Options (ISOs), Non-Qualified Stock Options (NSOs)

Primary Risk

Financial loss and tax liability if company valuation falls below strike price

Core Function

Equity compensation giving the right to buy shares at a fixed price

Key Components

Strike price, Vesting period, Grant date, Expiration date

Accounting Standards

FAS123 and APB 25 (US GAAP)

2005-06-01

Learn the fundamentals of stock options, including the different types, how they are granted and vested, and the process for exercising and paying taxes. Stock options are a form of equity compensation that gives an employee the right, but not the obligation, to buy a specific number of shares of company stock at a set price in the future. While both NSOs and ISOs are used for employee compensation, recent data on executive equity grants shows that ISOs are actually the more common form of stock option for executives at private companies. Exercising stock options is the act of purchasing the shares you have vested at your fixed strike price. Knowing what stock options are and how they work can help you make more informed decisions about when to sign your option grant, when to exercise your options, and what to do when you leave your company. Employee stock options give you the right to buy company shares at a set price in the future, usually as part of your compensation.

**NQSOs:** Taxes at exercise are based on the difference between the stock price on the date of the exercise and the option exercise price. A sale of shares from an ISO exercise can be considered a qualifying disposition and generally will avoid ordinary income tax upon exercise if, among other requirements, the following conditions are met:. **Capital Gain or Loss**: In general, selling shares from an ISO exercise in a qualifying disposition will not trigger ordinary income and the entire gain or loss (sales price minus cost of the shares) will be considered a long-term capital gain or loss. The amount of ordinary income is generally the difference between the stock price on the date of the exercise and the option exercise price. If you exercise your options and hold the shares, any dividends received on your shares are considered dividend income and are taxed as such in the year they are received.

Over the course of employment, a company generally issues employee stock options to an employee which can be exercised at a particular price set on the grant day, generally a public company's current stock price or a private company's most recent valuation, such as an independent 409A valuation commonly used within the United States. According to US generally accepted accounting principles in effect before June 2005, principally FAS123 and its predecessor APB 25, stock options granted to employees did not need to be recognized as an expense on the income statement when granted if certain conditions were met, although the cost (expressed under FAS123 as a form of the fair value of the stock option contracts) was disclosed in the notes to the financial statements. The IRS states that “you may deduct the amount by which the fair market value of the stock exceeds the option price when the employee exercises the option.” Because of this timing difference, cash taxes paid in the period when the GAAP expense is recognized are often higher than the GAAP tax expense.

They vest over time, can be exercised with cash or cashless methods, and are taxed differently depending on whether they are Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs).*. A stock option gives employees the right to buy company shares at a pre-set price, often below the current market price. A stock option is the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise” or “strike price.” Employees take ownership of granted options over a fixed period of time called the “vesting period.” When options vest, they are considered earned, though they must still be purchased. If options are exercised and the stock price decreases, the employee may lose both the amount spent on exercise and any associated taxes. Vesting schedules determine when employees gain the right to exercise stock options.