[First off, I’m pretty sure this thread will eventually be moved, but I’d like to get a few answers before it is.]
Okay, as I understand it, a stock option is the the privilege of buying stock at a set price, generally less than the current price of the stock. In the past, this was reserved for the most senior members of a corporation, but now many lower ranks, even as far as middle management, are now receiving packages. In addition, stock options are sometimes a reward for longtime employees, an incentive for good work, etc.
But why bother with this type of “futures selling” at all? Why not pay these deserving employees directly with stock? (I think some places actually do this.)
If you accept an option package, you do so in lieu of money or other benefits, since the package is a benefit…and on top of that, you have to spend more money to actually get the stock. Furthermore, an option requires you to purchase by a certain date. If you can’t make the date for any reason (inclduing not having enough money), tough, the option is lost. Unless you are a top-level manager, you’d have to be pretty devoted to the organization to accept such a bargain.
If the stock crashes or otherwise drops drastically in price for any reason (and considering the volatility of some industries, this is not a minor concern), to the point where the price per share becomes less than the fixed option price, the option becomes worthless.
If the company becomes hot property and other shareholders, not subject to time or quantity limitations (and willing to pay full price), buy up most of the available stock, that greatly lessens the value of your option, especially if the company has to issue new stock to meet demand.
If the stock drastically shoots up in value, that’s great…provided that it stays that high all the way up to the date where you can actually purchase the stock. Until then, all you can do is hope and pray that the price doesn’t plummet as drastically as it rose. I don’t know about all of you, but I’d find that downright torturous.
And here’s the really fun part. From the moment you accept an option, any increases in the value of the stock are treated, under AMT law, as taxable income…even if you never actually purchase the stock. So if you fail to meet the date, you actually lose money in the deal due to increased taxes. If you are able to exercise the option, you’re still not quite out of the forest, since that stock is taxed again when (or rather, if) you sell it. This is not double taxation, since it’s actually two forms of income; therefore each has its own tax. Needless to say, the increase has to be pretty substantial before you even break even, much less gain any appreciable income.
Finally, you’re expected to hold onto the stock for a while. There’s going to be pressure on you to not sell…as if the pressures inherent in the stock market weren’t bad enough. Remember, receiving a stock option means that the company has a lot of respect for you; it can be hard to go against the grain. If you are shameless enough to do it, you’ll be subjected to the short-term capital gains tax, which is considerably higher than the long-term tax, which, of course, just makes it all the harder to pull ahead.
Ask any of the “Internet millionaires” now saddled with six-figure tax debts how much fun those last two items are.
If it were up to me, I’d turn down any kind of option package and insist on getting paid stock directly. I’d gladly accept stock in my hands, to do with as I wanted, over an option package worth twice as much. If the value rises, I can wait until it peaks and reap a hefty profit. If it starts to plummet, I can cut my losses immediately. And I’m in a much better position to decide whether or not I should sell early or wait for long-term captial gains status.
I can understand why top executives like option packages, since they have the largest and most direct stake in the company. My question is, why does anyone else find them attractive? There seem to be far too many risks to offset whatever advantages they might have. What’s the appeal?
That’s a matter for managers/employees to consider. How much do you want to assume the risks/rewards of ownership? Provided options succeed in providing incentives to increase shareholder value, I would support them. If managers can’t stand the heat, they should exit the kitchen.
But do they succeed? I have 2 other problems with stock options:
Do they really mutually benefit managers and shareholders? Or are managers taking what rightfully belongs to the shareholders? Aren’t prices diluted if stock is sold at half price to someone?
Moral hazard: are managers tempted to time corporate activities to coincide with their options becoming exercisable?
As a former internet almost-millionaire (became a thousandaire, avoided going in the hole to AMT by one day - phew!) let me take a stab at this.
Why would an employee accept them? Well, if a company can’t afford big cash, then they’ll give you this instead. So, the choice may be to work for $N for GigantaCorp, or work for .85N + stock at TinyCorp. You’re not giving up tons of cash for the options, and there is a chance you could make it big. I remember seeing an ad for Netscape hiring before their IPO and thinking, “nah…”. Didn’t even send a resume. (kick kick kick.)
Here are the pros:
[ul][li]An option costs the employee nothing, it’s like a free lottery ticket.[/li][li]If the price goes up, you can exercise and sell the same day, eliminating any risk. If there are some other restrictions on your ability to sell, you should seriously consider not buying until you are clear to sell (see my story below.)[/li][li]Leverage. If you get 10,000 options vs. 1000 shares of stock, you have 10 times the upside potential and less downside if you are smart about the options.[/ul][/li]
Yes, the option eventually expires. This is usually 7 - 10 years later, so if the company does go public, or if it is already public, you are in decent shape.
True. But, if you didn’t exercise, the loss costs you nothing. If you had real stock, you’d have paid real income tax on the stock when you received it, and now may not get more out of the stock than the tax you paid on it.
I think you mean only if the company has to issue new stock. If other non-public investors come along, or the company issues new stock, your options are diluted. However, many companies will extend additional options to you to offset this effect.
Yes, but if you got paid in stock instead of options, you would have a very small fraction of the value you’d get in an option, so you lose just as much on the upside as options lose on the downside. Since it costs real money to give you stock, and just play money to give you options, you can get more from the company in options.
This is not quite accurate, but you are right that is the fun part. You are only AMT taxed on the difference in value between what you pay for the stock and what it is worth on the day you buy it, or on the day you ‘vest’, depending on your preference. Further increases in the stock are not subject to AMT. And, you must actually pay for the stock for it to trigger AMT, the “even if you never actually purchase the stock” is completely wrong.
The ‘double taxation’ effect is lessened by the fact that the AMT you pay is due back to you as a credit, so you may get the money back over a period of several years. Plus, you can get around it (as I did) by selling the stock the same tax year you buy it. Then, you have a real gain and are taxed just as regular income.
These are all true. Having been through this, I say this to the pressure: “F**k you, I’m not getting screwed again.” Still, knowing what I know, I think options are a powerful tool.
This sounds good, but your numbers are way off. First, you won’t get stock in your hands “to do as you wish”, you’ll get stock that you can’t sell until some time in the future. The point is to give you an incentive to stay, so let’s say that you get shares of stock and you can sell 25% of them after one year, 50% after two years, etc. Let’s go through a scenario.
Company A offers you $80,000 salary, and the option to buy 10,000 shares of stock at the current price of $10. You can exercise (and sell) 25% of the option after one year, 50% after two years, etc. It costs company A a pittance to offer the options to you. Someone else will have to fill in this detail. You are not taxed on the option until you exercise it in the future.
Company B offers you $80,000 salary, and N shares of stock for free. The current price is $10/share. How big do you think N is? Do you think they will give you 10,000 shares? How about 1,000 shares? Remember, to give you actual stock costs real money - they have to “pay” market value to give you stock. I think you’d be lucky to get 500 shares vested over 4 years for the same cost to the company as 10,000 options. You have to pay taxes (not AMT) on the stock at regular income tax rates immediately.
There are zero risks in an option if you don’t exercise them. If you do exercise and are unable to sell, there are risks. I learned this the hard way.
In the year 2000, my company went public in March. I bought the stock in February at pennies a share, when the ‘fair market value’ was half the IPO price. This means I was subject to AMT on the delta. We went public at $16/share and the price shot up to $37/share. My options were now worth much more than my silicon valley house was worth.
Downside: I was locked in until October. By then, the price slid to $9/share or so. Further complicating the deal, we were acquired and my stock got locked up in paperwork hell. I tore my hair out, but the stock came back on December 29th, and I was able to sell for about $3/share. Selling got me about as much money as my car was worth after taxes. Had I not sold that day, I would have owed $50,000 in AMT above what my stock was worth. But, selling in the same year wipes out AMT on the stock sold, so I made out with a nice bonus, but far less than it could have been.
Lessons I’ve learned:
[ul][li]Never exercise stock options until you plan to sell the stock and are clear to do so. In addition to avoiding AMT, options are more flexible than stock. If I had not exercised my options, I could have bought and sold them in October and not had to wait for the stock to be converted due to the merger. Had I known this, I would have made three to six times more money.[/li][li]If the options are going to expire and you must purchase or lose them, only purchase the options if you are willing to lose the money you spend.[/li][li]Sell the stock immediately upon purchasing. Do not wait for long-term capital gains, do not listen to peer pressure. This is your LIFE we’re talking about. See http://www.reformamt.org for some horror stories about why you should sell immediately, or at least sell immediately enough to cover AMT taxes.[/li][/ul]
That being said, I’m not any kind of tax professional. I just happen to have gone through this, and having done so I’d accept options gladly in the future - with the above lessons firmly in mind.
Benefit for workers: Leveraged participation in the company’s success, at no cost (see above caveats.)
Benefit for shareholders: Lowered cost of compensation for key employees, retention of valued employees.
Moral hazard: Nah. There are so many rules for when you can and cannot sell stock, especially if you are in a high position at a company, that it is difficult to see how this could be a problem.
I’d just like to add, as an investment banker, that in order for stock options to really motivate employees to add value rather than just handing them some of the company’s money, the options have to be out of the money. That is, if the stock is now at $10, one ought to give out options to buy shares at say $12, which gives employees an incentive to get the share price up to over $12.
" But, if you didn’t exercise, the loss costs you nothing."
Umm, are you sure? You get taxed at the rate of the stock at its high price if the price falls. So, if you get it at $20 & it falls to $5, the tax people charge you tax on it @ $20.00, right. I saw that happen on the news.
Been there, done that, got the tax forms in my filing cabinet. If you buy the stock, then you are taxed at the rate of the stock at the price it was when you bought it minus what you paid for it. This is close to what you are saying, but you do not have to pay on the high price unless it was at the high when you bought. Also note: If you never buy the stock, you never received a benefit, and you never owe tax. That is what I meant by
What you’ve probably seen is a story about someone who bought a ton of stock for $3/share when it was worth $90/share, then the stock plunged and they are taxed on $87/share. Brutal. But, if they had bought the stock earlier or later when the market value was $20/share, they would have been taxed only on $17/share. And, if they had sold the stock the same year they bought, there would be no AMT at all and they’d just pay tax on the actual gain they made (whatever they sold for - $3/share.)
If what you said was correct, I would currently be in negotiations with the IRS for rights to my unborn children. I bought stock at 5 cents per share, and it shot up to $37/share. I ended up paying taxes on $3 per share, because that’s what I sold the stock for. Had I not sold the same year, I would have owed tax on $8 on some and $16 on other shares. The stock is currently worth about 5 cents per share, so owing tax on an average of $12 per share would pretty much bankrupt me.
Handy, um, if you never exercise the option, you never own the underlying shares. You aren’t taxed on what you don’t own. I don’t even have to practice tax law to feel pretty confident on that one :).
Now, there’s another untidy mass of reasons for companies to issue compensation in the form of options: under the accounting and disclosure rules currently in place, companies did not have to record the value of the options (or indeed, any fraction of the value of the options) as a charge against earnings. Instead, the issuance of options was buried in footnates - as if the options either had no value (clearly wrong) or cost the company nothing (almost as clearly wrong). The problem has been determining exactly how much they cost the company. Tech companies screamed that if they had to record a charge against earnings every time they issued stock options, they’d be insolvent. To which many observers (including this one) said, “and your point…?” (For a more detailed summary of the issue and the opposing view, please click here*.) In light of the tech crash, pressure has been building for what IMHO would be a more realistic accounting, but the interested parties are tenacious lobbyists so I make no predictions.
In contrast, under most circumstances a direct, uncontingent grant of stock would have to be charged immediately against earnings.
A couple of definitions will help in understanding the cited article. P & L is profit and loss. FASB, the Financial Accounting Standards Board, is responsible for the care and feeding of the U.S. version of GAAP, Generally Accepted Accounting Principles.
Speaking from Silicon Valley here. Not too much to offer in the way of facts, just my story.
I joined my company in February of last year. I joined because I wanted to get rich, even though the job was a bit of a step backwards. The stock price was about $145, so I was given options for X shares at $145. (You get shares at pennies a share if you join pre-IPO, otherwise your options are at fair market value.)
Within two weeks the stock price was at $200. I thought, “SWEET!” However, it’s SOP to have a one-year vesting period, i.e. you can’t exercise your options for one year after you were granted them.
August of last year, our company merged. At that time, however, the price was $80 a share.
January of this year, I got a bonus. The price was $35 a share. I thought, OK, no problem, if it goes up to $600 a share eventually, I’m in clover.
Last week, I got laid off. The stock price was about $7 a share. I spent 18 months at an unchallenging job, doing major damage to my career. I still haven’t ever exercised a stock option for that company, and they expire 30 days after you no longer work for them.
I’m sitting at home in my bathrobe, planning my day with the TV schedule and a highlighter pen, surfing the net and cursing my mistakes and greed.
Again, not much to offer in the way of facts, just my story. All I ask for is your pity. Thanks!
I’m not sure if anyone’s mentioned this, but stock options are often used as “golden handcuffs” - that is, money that you will get if you stick with the company. They do this by not giving you your stock options all at once - they only give them to you a few at a time, over a period of years. For instance, in my company, our options “vest” (become the property of the employee) slowly over four years of continuous employment. This means that you have to keep your crappy job for four years if you want to sell your option’d stock. My company is nice enough that at the end of four years, the stock that you would have to buy and then re-sell (options) are given wholly to you as a gift. Most companies are not that nice.
Which would all be great, if it weren’t for the fact that A) I was hired right after the IPO, when the stock price was amazingly inflated. My options came at a price of $37/share - the company is now trading for $3 a share. And B) the work is not interesting or challenging, and management in the company seems to enjoy the “everything is an emergency” mentality. In short, my options are worthless. Worse than that, actually, because the current price is so far below the price I was granted my options at. If I were fully vested today and could sell all my stock options (which I’m still three years away from), I would have to “buy” the options from the company at $37/share. Then I could turn around and sell the shares for $3/share. I have (or will have) 1,500 shares. I would take a loss of almost exactly $50,000 if I were to do this.
So, my opinion as an employee is that stock options should be used with care. Right now, I’m quite annoyed with my company for giving me options that are utterly worthless - even negative in value. Why did they even bother giving me options? Exactly how stupid do they think I am? This supposed to be an incentive for me to work hard?? This company will never again see a share price of $37/share. Not in my lifetime, anyway - and I rather suspect it will die before I do. Right now my stock options are looking pretty shitty. As a matter of fact, now would be the perfect time for me to quit and get re-hired at another company whose stock is very depressed because of the whole dot-com bust. I would get options at a very few dollars a share, and there’s nowhere to go but up. (An action which, as a matter of fact, I’m actively planning for.)
In short, if you’re an employer and you offer options, be sure they’re worth something - or risk losing your employees in droves. And if you’re an employee who gets options, be sure your options aren’t worthless. Also remember that A) your stock options are not yours until they’re fully vested - until then you’re on the treadmill, reaching for the carrot, and B) stock options are not worth the grant price - they’re worth the current price MINUS the grant price. For example, if your company grants you 100 shares at $5/share, and the current price is $7/share, then your options (assuming they’re actually vested - which may be several years down the road) are not worth $700. They are worth (100 * 7) - (100 * 5) = $200.
I don’t object to stock options in general. I think they’re a fine method of motivation. But they must be employed cautiously, lest you seriously annoy your employees.
-Ben
In this discussion, be careful to distinguish between the terms “exercise” and “vest”. “vesting” refers to having shares that you may exercise. Typical plans vest at some rate over a period of years. “exercise” means you actually take some action to buy some portion or all of your vested shares.
Typical vesting might look something like “you vest 1/4 of your shares after 1 year, the remaining to be vested monthly over the next 4 years after that.”. That kind of deal used to be sort of a Silicon Valley standard for ISO’s. The initial year is sometimes called a “cliff”. There are an enormous number of variations on vesting schedules, however.
As a couple of people have noted, you don’t incur tax penalties unless you exercise. In effect, if you want to completely ignore the option, it costs you nothing.
Another important thing to be aware of is that there are two major types of options - non-qualifying and ISO (“incentive stock options”). ISO’s are the ones with a sting in the tail concerning AMT, should you choose to exercise and hold the shares.
AMT is only an issue if you choose to exercise and hold (the reason for doing this is that by holding for a year you realize long term capital gains, taxed at a lower rate). If you exercise and sell the things, you’ve just created normal income. NQ options are also seen as normal income whenever you exercise, whether you hold them or not. ISO’s are not normally taxed after exercise until you actually sell the shares, EXCEPT that you are liable for AMT.
AMT is exceedingly complex. A good rule of thumb is that if you have three times the possible AMT liability in normal income, you won’t get hit, but that is ONLY a very crude estimate.
Some people handle exercising and holding ISO’s by exercising and selling some portion of their shares so as to create enough income to protect the rest of the exercise from AMT. Whether this is a good idea or not depends on your individual situation, and what you think will happen with the company’s stock in the future. If you really think it will be worth a lot more in the future, you’re giving up that potential gain. On the other hand, if you think it would be a good idea to spread the risk a bit by cashing some portion of your compay’s stock and moving it elsewhere, it may be a reasonable approach.
Most option plans will have an allowance for “same day sale” which allows you to sell shares, taking the price out of the proceeds from the sale, so that you actually don’t have to come up with the money if you just wish to sell the shares immediately. They may or may not withhold tax automatically when you do this - be careful.
I’ve had options from 3 companies at this point, not counting options converted from one company to another through acquisition.
It’s partially a crap shoot. Unfortunately, it’s the way you are going to get financially secure, as opposed to merely making a good salary as a technical professional.
It behooves you to learn about them, so as to try and take some of the roulette wheel aspects out of the game.
Acquisition is another interesting issue. By far and away the option which yielded me the greatest return is my current employer - Sun. I worked for a pre-IPO startup that was acquired at the right time with respect to the Sun stock price. Our options were converted to Sun stock, and we got liberal extra options as “signing bonuses”.
From my experience, I would say there’s a lot to be said for going to work for a pre-IPO company that’s past its initial “garage” phase. You won’t get founder level stock, but you’ll generally get a better slice than you will post-IPO, and you can have some idea that the company isn’t going to completely fizzle - either they may eventually go public, or be bought out in a reasonably friendly fashion.
Companies generally WANT to give employees as cheap an option price as they can. If the company is publically traded, the price is fairly clear cut. Pre-IPO, there are some very arcane SEC regulations they have to follow, which are largely voodoo, quite frankly. If you are being offered options in a pre-IPO company, DO ask how many shares are authorized, figure out what (very small) fraction of the company the shares represent, and use that to guess what they might really be worth, should the company become successful. Startups sometimes authorize utterly huge numbers of shares, so that they can impress potential employees by offering them 120,000 shares at a nickel a share, or something like this. It may or may not be attractive, depending on what kind of percentage slice this represents.
I would just point out that what everyone is talking about here is being granted long call options. The company granting those long call options are then short those same call options. Options are a zero sum game, there is one long for every short. There are also put options, and both puts and calls can be either long or short.
So, just want readers to be clear that what is being discussed are long call options granted to employees.