What Are Stock Options? How to Explain Them to Employees

One of the smartest moves you can make is to share the future upside of your company’s growth with key employees by granting stock options. But doling out the options isn’t good enough. You also need to make sure your employees understand exactly how options work, and how best to incorporate options into a comprehensive financial plan.

Think that’s not your job? Wrong. The reason you decided to include stock options in your company’s compensation mix is to motivate and retain current employees, and help lure more top talent to your shop. So explain to me what happens if those same employees end up making a mess of their options--and their entire financial security--because they were ill-informed about the arcana of stock options. Can’t you imagine they might be a little less motivated and a little more annoyed and distracted?

That’s the business manager argument for making sure your staff is schooled on stock options. There’s also the leadership argument: Anyone can be a CEO, but not everyone is a bona fide leader. Leaders put their employees in the best possible position to succeed. If you are responsible for granting stock options, you are responsible for making sure your employees know how to successfully handle their stock options.

Relying on the legal documents that come with stock grants isn’t what I am talking about it. Satisfying compliance isn’t the goal. This is about plain-talk communication. Here’s what every employee deserves to be taught--yes, taught--about their stock options.

Lay out the timeline.

Explain how many years the employee has to exercise the options before they expire. Bonus credit to your leadership skills if you also touch on how waiting until the last year or so to exercise can backfire: There is no way to know what the markets, and your company stock will be up to in that short time frame. Moreover, there can be a bigger tax hit by exercising a big pot of options in any single year. (More on taxes in a sec.)

Explain the vesting options and scenarios.

This is where you can review the vesting schedule and explain that any options that have yet to vest will vaporize when the employee heads for the exit. Next, cover the timing for exercising vested shares when an employee becomes an ex-employee; typically there’s a short 90-day window when the former employee can exercise vested options. Couldn’t care less if someone who’s leaving loses out on those options? Okay, then I am assuming you don’t care about an ex-employee bad-mouthing you. And who’s to say that ex-employee won’t be a future collaborator or business partner. We all know it’s a series of small interlocking worlds we work in.

Clarify the tax implications.

When you exercise, the IRS takes a big tax cut that you can’t avoid. (And your state tax dept. may get a cut as well.) Assuming you have issued non-qualified stock options (NQSOs), you seriously owe it to your employees to make sure they absolutely understand the tax implications of exercising their options.

The first point: All profit is taxed as ordinary income (highest current rate 39.6%). Not capital gains (highest current rate 15%). Drill that home. Make it very clear that no matter how many years they have held the option, they will pay ordinary income tax on the difference between the original grant price of the option and the price on the day they exercise the stock.
That brings you to crucial tax point #2: Even if they elect to exercise and continue to hold onto the stock, they still owe the first tax based on their profit on the exercise date. That income tax is due no matter what happens to the stock from that day forward. Even if the stock subsequently falls below the exercise price, the tax is still due on the price differential on the day of the exercise. It was wrenching to see so many brilliant Silicon Valley entrepreneurs learn this the hard way in 2000 and 2001 when they faced big tax bills for stock that had subsequently tanked after they exercised and held on.
One final tax angle to cover: The tax bill if they choose to hold onto a stock after exercising. Explain that there’s a second tax bill that starts accruing on the date they exercise. It isn’t due until they sell the stock. The tax is based on the difference between the exercise price and the sale price. If they sell at a gain in less than one year, they will owe ordinary income tax on that sum. If they sell after one year, any profit will be taxed as a long-term capital gain. If they sell the stock at a lower price than the exercise price they can claim a capital loss on their tax return.

Preach the merits of diversification.

Your employees need to get schooled on why it is insane to have all their money tied up in one stock (unexercised options and exercised stock they continue to own). Yes, even your company’s stock.

If that makes you squirm--or legal gives you an earful about what they are comfortable with you saying--hire an unbiased third party financial advisor to do the explaining. If you have a 401(k), the plan provider likely has some educational material on the perils of single-stock concentration and the advantages of diversification. Just make sure the diversification conversation is had; avoiding the topic altogether is simply not an option if you truly are a leader.

How to Explain Stock Options to Employees