What Is an Option Grant and How Does It Work?

An option grant is a form of employee compensation that provides the recipient with the opportunity to acquire company stock. Companies use these grants to align employee interests with shareholder success, fostering ownership and incentivizing contributions to growth and retention.

Understanding Stock Option Grants

A stock option grant conveys the right, but not the obligation, to purchase a specified number of company shares at a predetermined price within a set timeframe. The terms of these grants are detailed in a Stock Option Agreement provided by the employer.

The grant date marks the day the options are officially awarded to the employee. At this time, a strike price is established. This fixed price is what the employee will pay for each share when they choose to buy, regardless of the stock’s future market value. For instance, if the strike price is $10 per share, the employee can buy shares at $10 even if the market price later rises to $50.

A vesting schedule dictates when the options become exercisable. Vesting can occur through “cliff vesting,” where all options become exercisable on a single date after an initial waiting period, or “graded vesting,” where portions of the options become exercisable over time, such as annually for several years. Until options are vested, they cannot be exercised.

An expiration date sets the deadline by which the vested options must be exercised. If options are not exercised before this date, they become void. This date is often 10 years from the grant date, though it can be shorter, especially if an employee leaves the company.

The lifecycle of a stock option begins with the grant, followed by the vesting period. Once vested, the employee can choose to exercise the option, purchasing the shares at the strike price. After exercising, the employee owns the shares and can then decide whether to sell them immediately or hold them for potential future appreciation.

Types of Option Grants and Their Tax Implications

Stock option grants come in two types, each with distinct tax implications: Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). The tax treatment varies depending on the option type and how long the shares are held.

Incentive Stock Options (ISOs)

Incentive Stock Options (ISOs) are granted only to employees and must meet specific Internal Revenue Service (IRS) requirements. No regular income tax is due when the options are granted, vest, or are exercised.

However, the difference between the strike price and the fair market value (FMV) of the stock at exercise, known as the “bargain element,” is considered income for Alternative Minimum Tax (AMT) purposes. This can trigger an AMT liability, a parallel tax calculation designed to ensure certain taxpayers pay a minimum amount of federal income tax. For a “qualifying disposition,” shares acquired through an ISO exercise must be held for at least one year from the exercise date and two years from the grant date; any profit upon sale is then taxed at lower long-term capital gains rates. If these holding periods are not met, it results in a “disqualifying disposition,” and a portion of the gain may be taxed as ordinary income.

Non-qualified Stock Options (NSOs)

Non-qualified Stock Options (NSOs) can be granted to employees, consultants, or board members. Unlike ISOs, NSOs do not receive preferential tax treatment. There is no tax when NSOs are granted or vest.

However, when NSOs are exercised, the difference between the strike price and the fair market value of the stock on the exercise date (the “bargain element”) is immediately taxed as ordinary income. This income is subject to federal income tax, as well as Social Security and Medicare taxes. After exercising, any further gain or loss when the shares are sold is treated as a capital gain or loss. If the shares are held for more than one year after exercise, the capital gain is considered long-term and taxed at lower rates; otherwise, it is short-term and taxed at ordinary income rates.

Exercising and Selling Your Options

Once stock options have vested, employees face the decision of how and when to “exercise” them. Exercising an option means purchasing the shares at the predetermined strike price. This transaction converts the right to buy shares into actual ownership of company stock.

Several methods exist for exercising options. A cash exercise involves using personal funds to pay the strike price for the shares. This method requires sufficient cash readily available to cover the purchase price and any associated taxes.

A cashless exercise allows employees to acquire shares without an upfront cash payment. In a “sell-to-cover” cashless exercise, enough shares are sold immediately upon exercise to cover the strike price, taxes, and fees, with the remaining shares being delivered to the employee. Alternatively, a “same-day sale” involves exercising and selling all the acquired shares in one transaction, with the net proceeds (after costs and taxes) paid to the employee. Another variation is a stock swap, where existing shares of company stock are used to pay the exercise price for new shares, reducing the cash outlay.

After exercising options, the employee owns company shares. The decision to sell these shares can be made immediately or at a later date. Shares can be sold through a brokerage account, similar to other publicly traded securities. The profit or loss realized upon selling the shares will depend on the market value at the time of sale compared to the cost basis, which includes the strike price and any income recognized at exercise.

Exercising and selling options are distinct financial events, each with its own timing and tax implications. The timing of these actions can significantly impact the overall financial outcome for the individual.