Wednesday, January 25, 2006

The Wonderful World of Employee Stocks, Part 4: Stock Options, And Why Thinking About Them Makes Me Squeal Like a Schoolgirl

Author: Nick
Category: Money
Topics: ,

Squeee! Stock options! Squeee!

I’m okay. I’m okay. And if you happen to be a Google employee with a bunch of company stock options, you’re probably much more than okay right now. That’s because, with a few magic words from your employer and some lucky market timing, these little things called “options” can make millionaires out of anyone fortunate enough to be entitled to them. Now chances are if you have time enough to spend reading my lowly blog that you’re probably not swimming in stock options, so this will be more of a “what if” for you. But maybe one day you’ll come up with an idea that makes your company billions and they’ll thank you with a handful of stock options. Then you’ll come back to this blog on its 30th anniversary to read up on what stock options are, and you might just invite me to visit you on the private island you’ll purchase with the money you make from selling your options.

Stock Options. Yup, That’s What This Is About. What, Are You Waiting For Me To Say Something Funny Here? Okay, Fine. Ummm … Cheese Doodles! Now Read The Article Already!

The basic theory behind stock options is pretty simple. When your employer gives you stock options, it is not really giving you stock. Instead, it’s your employer’s way of saying you will have the ability during some period in the future to exercise your option to purchase stock. The trick to stock options is that your employer sets the price at which you can purchase the stock, and if you choose to use your options to purchase the stock, you’re guaranteed to pay that price and no higher.

There are a few things to keep in mind if you ever find yourself with some options. First, your options are only valid for a limited time. If you don’t exercise them by the time they expire, you gain nothing, but you also lose nothing because you didn’t buy any stock. Second, unlike ESPPs with their built-in discounts, options do not automatically mean free money for you. It’s quite possible that the stock’s price will drop or stay below the purchase price your employer sets during the option period. Fortunately, as long as you know basic math, you won’t lose money if this happens; you’ll just have worthless options. Third, you might not be entitled to use all of your options when you first receive them. They may be gradually vested, meaning that you might be able to use some of them one year, some the next, and so on.

The stock shares you buy with options, unless they’re restricted (we’ll talk about this in a moment), entitle you to all the rights of being a regular shareholder for as long as you hold the stock. Vote in big decisions, check your stock’s price compulsively, or just brag to your friends that you own stock and are therefore so much cooler than they are.

Case Study: Exercising Your Options … In My Pants!

Let’s look at an example involving a sadly imaginary business. Say I own The Butt-Hugging White Pants Company and I’ve just hired you on to head our Shiny Gold Zipper Design Department. You’re the best in the field of shiny gold zipper design, so I want you to stick around for a good long time designing shiny gold zippers for us. So I pay you well and give you 800 stock options in the company. Those options are 25% vested each year for the next four years and each option entitles you to purchase one share of NYSE:BUTT for $10. The options are good for four years from the start of the first year of vesting. Good so far? Not really since you haven’t actually made any money yet. But hold on to your pants ’cause it’s about to get windy!

Year One of your four-year option period comes around. BUTT starts the year trading at $15 a share. You could exercise 25% of your 800 options to buy 200 shares for $2,000 ($10 x 200 shares) and then immediately sell them on the open market for $15 a share. You’ll make $1,000 if you do it this way, but you decide to hold on to your options. The third-quarter earnings go through the roof thanks to the discovery of a new shade of white denim that sells millions of pairs of pants in under a month. The stock price jumps to $30 a share and you decide to exercise those 200 vested options. You spend $2,000 to buy the stock and sell it for $6,000. You’re $4,000 richer, and after a week’s vacation in Hawaii, you come back to work and crank out the best darn shiny gold zippers ever made.

Unfortunately that new shade of white denim turned out to be poisonous and your company’s stock plummets in Year Two of your option period to about $12 a share. You could still exercise your newly vested 200 options and make $400, but you decide to hang on to your options going into Year Three.

Now equipped with your fantastic new shiny gold zippers, Butt-Hugging White Pants start selling fairly well again in Year Three. The stock price rises to $20 and you sell the 200 options left over from last year plus your 200 new options from Year Three. The 400 options at ten bucks a pop costs you $4,000, but you sell them for $8,000. You’re another $4,000 richer.

Year Four begins and you’ve got your final 200 options. The weather’s nice outside … a little too nice. Turns out that white denim was not only poisonous but it was also punching a big hole in the ozone layer. The entire country sees record highs, and while the only thing on people’s minds is looking good, the only things on their thighs are shorts and skirts. Our company sells pants only, so we have a slow sales year. The stock price sinks to around $5.25 a share heading to the end of Year Four.

At this point, you have a couple of options (and I’m not just talking about the 200 stock options you have left). On the one hand, you can do nothing with your options and they’ll expire at the end of the year. No money gained, but none lost. On the other hand, you can exercise your options and immediately sell your shares. You’ll only make $50 ($.25 x 200 shares), but at least you’ll be able to pay your bar tab at the end of the night. On the third hand (you three-handed freak!), you can exercise your options and hang on to the stocks for however long you like. While the options might expire at the end of the option period, you can use them and keep the stock indefinitely. Hopefully the weather will cool off next year and pants will begin selling again.

Sadly, you don’t get to choose from any of these options. Instead, you resign in shame after the President of the United States has a highly publicized painful zipper accident while traveling through Europe. You guessed it; he was wearing Butt-Hugging White Pants with your latest shiny gold zipper design. In this case, since you quit willingly, you forfeit your remaining options. But that’s okay, because the company never recovers from that incident and I’m soon fleeing the country when the SEC begins poking its nose into our, ahem, pants.

Other Fun Things To Know About Your Options

If you make so much as a penny with your options–surprise, you’ll pay taxes on your profits. Taxes on options can be worse than those on ESPPs because, under certain conditions, you may have to pay taxes twice on options you exercise. The first time will be when you originally use the options to buy stock. If the price your employer sets for your options is lower than the market price for the stock, you’ll typically pay regular compensation taxes on the difference. Once you sell your stock (if you decide to hold on to it), you’ll pay taxes again if the stock price went up since you bought it. Also, depending on the type of stock option, you may only have to pay long-term capital gains taxes if you hold the stock for a period of time.

Another tax note about options: these babies could throw you clear into Alternative Minimum Tax (AMT) Land. If you exercise a ton of options in a single year or the gap between the purchase price and sale price is fairly large, you might trigger the AMT. You can read more on the AMT and stock options in this article from The National Center For Employee Ownership.

One nasty trap to be on the lookout for is options that only allow you to purchase restricted stock. As the name suggests, there are restrictions on stock purchased with these options that could prevent you from selling your stock immediately or force you into selling it back to the company (possibly at a loss!) should you leave the company. Be very careful when playing with restricted stock options.

Finally, another event that might take place during your option period is known as repricing. If your company’s stock takes a tumble, it may reprice your options lower. Your options to buy shares at $10 a piece might allow you to buy stock for $5 a share if your company reprices the options. Companies sometimes do this so that a big employee incentive doesn’t become worthless and employees don’t start generating tons of resumes on the office copier. As simple as this might sound, there are rules restricting businesses from doing this whenever they feel like it.

Summary of Stock Options

Oh come on! Don’t tell me you skipped down to here again. But that means you missed a great story about pants and stock options! Okay, on with the summary.

  • Stock options let you buy stock later at a price decided earlier. When you exercise your options, you can buy stock for a price your employer sets ahead of time. Generally you’ll wait until the market price is higher than your purchase price, and then you’ll sell for a tidy profit. In the meantime, while you hold the stock, you have all the powers of a normal shareholder.
  • Options expire and can be vested over time. If you don’t exercise your options after a limited amount of time, you lose them but your wallet is left untouched. You might not be allowed to use all of your options right away; you could have to stay employed with your company for a while to get access to all of them.
  • When you make money, you pay taxes. Yup, same third bullet from the ESPP discussion. Be extra careful with options since they can be taxed at option exercise and stock sale time, and you might even trigger the dreaded AMT.
  • Watch out for restrictions and repricing. Restricted stock options can limit your ability to turn a quick profit with your options. In times of financial woe, your company may reprice your options so that they retain some of their value.

And that, ladies and gentlemen, is just about everything I know regarding employee stocks. Be sure to check out the other parts in this series if you missed them…

Part 1: Getting Started on Owning One Billionth of Your Company
Part 2: Getting Soppy Over ESOPs
Part 3: Don’t Poo-Poo Your ESPP

…and look for more delightfully informative series from Funny Munny soon.

No comments yet.

Sorry, the comment form is closed at this time.