What are stock options in a compensation plan?

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The idea behind a stock incentive plan is simple: people work harder for the things that they are invested in. The theory is that by owning stock in the company you are more likely to feel devoted to and personally invested in the company’s success and that this will manifest in higher performance.

If stocks are part of your compensation package, they are typically paid to you in much the same way your salary is—a set amount on a set schedule. Stock options however work a bit differently.

How Stock Options Work

The general incentivization theory is the same, people feel invested in what they’ve literally invested in, but the financial and contractual mechanism is a bit different. Stock options are in some ways exactly what they sound like, the option to purchase company stock.

How is this an incentive you may ask? Don’t we all have the option to purchase any stock we choose? Of course, but that’s why stock options come with some perks and some limitations.

Stock options are essentially a contract between you and your employer that lays out structured options for you to purchase company stock at a fixed price. This price is normally set below the market rate at the time of the contract negotiation. This price is often referred to as the grant or exercise price.

Your stock option contract will also include a specified number of shares that you are eligible to purchase at the exercise price. These shares may or may not be available to you all at once.

Vesting Periods

Typically, stock option contracts include rigidly defined timeframes for when you can begin to exercise your stock options. Most companies require you to work with them for a certain number of years before you can begin exercising your stock options. The length of time you have to be employed by the company in order to exercise your options is called the vesting period.

Some companies allow you to exercise all of your stock options once you’ve passed a specific amount of time. For instance, after five years you would be allowed to purchase the full amount of shares eligible to you under your stock option contract. This is referred to as cliff vesting when your options vest all at once.

Other companies may choose to spread out your stock options over time. This is called a graded vesting schedule. Under a graded vesting contract, you would gain access to exercise your stock options slowly over time. An example of graded vesting would be the option to purchase 500 shares after one year, 1,000 shares after two years, 2,500 shares after three years, and so forth for a length of time designated by your contract.

ISOs and NSOs

It’s also important to understand that there are two types of stock options that can be included in an employee compensation plan. ISOs or incentive stock options and NSOs or non-qualified stock options.

The main difference between non-qualified stock options and incentive stock options is in how they are taxed.

With an NSO you are taxed on the difference between the exercise-price in your stock option contract and the market value of the stock when you purchase the stocks. That’s because the difference in price is considered compensation.

ISOs however qualify for special tax exemptions as long as you hold on to the stock for at least a year after you’ve exercised your purchasing option and bought the stocks at least two years after you were offered the stock options. If you sell your ISO stocks within a year of purchasing them you’ll likely have to pay short-term capital gains taxes on the difference.

It’s important to understand the difference between types of stock incentives, timelines, and tax implications to make the best choices for your unique financial situation, but each has its merits and can be a gainful option in your compensation plan.