Incentive Stock Options Explained
In this episode, we dive deep into the world of stock-based compensation, shedding light on how Incentive Stock Options (ISOs) work and the strategies that can help you maximize their benefits. Steve Moyer, vice president of executive compensation & corporate offerings, joins our host, Valerie Escobar, senior wealth advisor, to simplify the complexities of executive compensation and ISOs. Listen to Part 2 to learn about the taxation of stock options.
Valerie Escobar: Today we’re going to hit on something called incentive stock options. People love to hear stock options because they think it’s super cool and sometimes it’s more just difficult. And so we are going to discuss exactly what they are and if they really are cool at all.
I’m Valerie Escobar, certified financial planner with Mariner, and you’re listening to Your Life Simplified. Today I am joined by Steve Moyer, VP of executive compensation and corporate offering. Steve, thanks for being here.
Steve Moyer: Yeah, thank you for having me.
Valerie: Okay, today we are discussing incentive stock options, which may or may not be cool. Can you weigh in?
Steve: Well, look, I think they’re extremely cool, and I work with them quite a bit. And yeah, it’s a unique opportunity, and I think for those who receive options, it’s important to understand what that opportunity looks like.
Valerie: Perfect, yes. And so I think one of the first things I want to discuss is what an option is. Oftentimes, I hear someone say, “Yeah, they’re going to give me an option,” but they don’t understand that what an option is is the ability or opportunity to buy something. So that option itself is not… like, they’ve not given you a big bag of cash, they’re just giving you the ability to buy something.
And so, in my simple brain, sometimes I like to put it, use something tangible to help me understand it. And so, let’s say that your neighbor said, “Hey, Steve, you can buy this house for a hundred thousand dollars.” And you’re like, “That’s cool, because I could probably sell it for $200,000.” So you’re getting the ability to buy it for a hundred, but you’re not actually getting the house. Does that sound right?
Steve: Yeah, I think that’s valuable. Not knowing what the future holds, when I think of it from that perspective, even if they give me the option to buy it based on what the current price is, but it has the possibility of going up in value, but I don’t have to make that decision until I know if it’s going up in value, that’s extremely valuable. On the other hand, if it goes down in value, maybe I choose just to not do anything.
Valerie: To not do anything. Perfect. Yep. So that’s exactly what I wanted to talk about today. So there’s two main kinds. So instead of stock option and unqualified, what’s the difference between the two?
Steve: Yeah. So the biggest difference is that incentive stock options, or qualified stock options, are eligible for potentially favorable tax treatment. And so what that means is the net after-tax benefit that somebody can get out of their option can be potentially a little bit higher with an incentive stock option versus the nonqualified version.
Valerie: Okay, perfect. So we’ll talk a little bit about the taxation in our next episode. Teaser. This is a two-parter. There’s a lot in these episodes, so we will hit that a little bit later. But let’s talk about some of the basic terminology. So grant date, let’s start with that. What’s a grant? How does that impact us?
Steve: Sure, sure. Grant date is simply the date that options are awarded to an employee.
Valerie: Okay, perfect. The vesting schedule.
Steve: Yeah. So most of the time options cannot be what we call exercised, and we’ll talk about that I think a little bit later, until the vesting schedule has been met, until the vesting event has happened. So what it means is from the date of award or receipt to the date of vesting, there’s really not much that can be done. After the vesting event has happened, then the employee has some decisions to potentially make.
Valerie: Okay, perfect. Let’s say that we’ve reached our first vesting date. What is a relevant piece of data, maybe is our strike price.
Steve: So strike price, also known as the exercise price, or some companies would call it the grant date price—it’s all the same. And what that is it’s a fixed price at which an employee is allowed or able to purchase shares for. And almost all the time, the strike price is equal to the fair market value of the stock on the date of grant.
Valerie: Okay, perfect. So two years ago, I got the grant. It was worth $10 and now it’s worth 20 bucks.
Steve: Yes. Yes.
Valerie: So what’s the bargain element?
Steve: Yeah, so the bargain element, we would also call that the spread or in the money value, but what it is is the difference between the current stock price and the strike price. So in your example, current stock price is $20 per share, the strike price is $10 per share, that’s a $10 gain per share, and that’s the bargain element.
Valerie: Okay, perfect. And so again, we have now an option. So it’s vested and now I can use that option. I have the option to go out and buy this $20 stock at $10. Should I go ahead and do that?
Valerie: Perfect. Yes, as all things.
Steve: So after vesting has happened, you could. Options also have another deadline that’s important, too. And that’s called the expiration date. And so, really, somebody can have an exercise window, is what I would call that, where they could exercise the option anywhere between the vesting date and the exercise date. Now, if the options are in the money and they’re vested, somebody could choose to exercise, extract that value. Or, if they think the stock price might continue to go up, they may choose to sit and wait before they exercise to see if the price actually does go up.
Valerie: Perfect. So, it’s not just saying automatically that as soon as we get our vesting that we should necessarily go out and buy it?
Steve: That’s right.
Valerie: Okay, perfect. And so, we talked a little bit… I guess, what are some of the things that someone could take into account in evaluating that choice?
Steve: So, I like to say when it comes to options, there’s really two main decisions that somebody needs to make. The first is, when should I exercise my option? And then the second choice, once we’ve determined it’s time, is how should I exercise my options? The when should I exercise my options. So our approach is we like to start by evaluating options, full potential value, is what we call it. So most of the time when I ask somebody what the value of their options are, what they say to me or calculate for me is the spread or in the money value, that bargain element we talked about.
And so again, how they get there is they take the current price minus the strike price times the number of shares they have. And that’s what they tell me their options are worth. And in one regard, that’s true. That is what they’re worth. But that’s what they’re worth at a point in time: today.
Valerie: That day.
Steve: They’re also worth potentially more. And the reason is because options have this other value that we call time value. And what time value represents is how much growth potential remains in an option. So when we think about the value of an option or the full value of an option, we like to start with what we call the full potential value. And again, it’s comprised of what they’re worth today plus what they can grow to become worth in the future.
Now oftentimes, I’ve found that folks either don’t recognize there’s a time value component, or even if they do, they don’t always know how to quantify it. So what they’re really left with is trying to make decisions based on that in the money value. And I’ve found in my experience, it leads to one of two types of decisions. One is an emotional decision, which is how they feel about that value at any point in time. The other is a speculative decision, which is where they think the stock price might go.
So again, we like to start with the full potential value of an option, and then once we understand that and the different parts, we can kind of rework those parts to better understand when it may be best to exercise an option.
Valerie: Okay, perfect. And then when you were mentioning the speculative aspect to it. Sometimes we’re looking at stocks that are on private company versus a public company. Can that weigh into it at all?
Steve: It can, yeah. So all else ask being equal, sometimes with private companies there’s more growth potential and that growth potential can occur very rapidly. And in some of those cases, we might look to exercise a private company’s options a little bit earlier than we might a public company that’s maybe a little bit more mature and doesn’t have the same growth prospect, so to speak.
Valerie: Okay, perfect. And so again, we are exercising a stock, which means I’m buying my neighbor’s house at, it’s worth 200,000 today, but my option says I can buy it for a hundred thousand. And I feel that that house is appreciating in value super rapidly. And so what you’re telling me is that if I go ahead and buy it for 200,000 because I believe it’s going to be worth a million dollars in one year, that that’s a good thing for me, right? So when would it be like maybe, I guess on the opposite side?
Steve: So how we look to make exercise decisions, at least with options, is we would take the time value…
Valerie: Right. And tell me again time value. So define that one a little bit more.
Steve: Yeah, so time value is a calculation of approximately how much value remains in the future.
Valerie: So basically, if it’s going to expire soon or way out in the future.
Steve: That’s right. Okay. So all else being equal, let’s say there’s two options we’re taking a look at. One has one year until expiration, another option, same terms and everything, except they have seven years into expiration. The one with seven years is going to have a higher calculated time value because there’s more time for the price to potentially go up.
Valerie: Okay, perfect. So I think on this with incentive stock options, we can, obviously, there’s so many different components to it. And so speaking with an advisor that has a lot of knowledge and experience around that’s going to be super important. And one other thing that I think we talked about how there are qualified and nonqualified. Is it possible that we have a qualified option and then we somehow make it nonqualified?
Steve: It is, actually. So a number of things can lead towards a qualified stock option becoming disqualified or becoming a nonqualified option. One of them is something we call a $100,000 rule. It just means that only a certain amount of incentive stock options can vest in the same calendar year. And if too many vest, some of them become disqualified. They are converted essentially to a nonqualified stock option.
Other things would be like termination is a common one. So if somebody terminates employment, oftentimes, they may forfeit all of their unvested awards, but let’s just assume somebody terminates and they vested in all of their incentive stock options. They only have, and this is a requirement of section 422, they only have 90 days to exercise their incentive stock options, and if they don’t, then they would convert to nonqualified stock options.
Valerie: So, I’m glad you know all these tax laws, I don’t even know… what is it called, sections, the rules? But yes, very specific rules regarding all of the way that we exercise them and some of the methods in which we do it. Next time, what we want to talk about is the taxation. I think that’s the biggest part, especially when we talk about qualified, unqualified. And then, also, we are going to purchase our neighbor’s house for $200,000. Where’s the money coming from?
Steve: That’s right.
Valerie: Thank you for joining us on today’s episode of Your Life Simplified. We hope that you will ‘Like’ and subscribe wherever you find us and be sure to join us next time.
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