Start of our guide to nonqualified stock options.
Nonqualified stock options are a popular form of equity compensation. Companies like them because they provide a flexible and efficient way to attract, retain and motivate employees (and other service providers, such as directors and consultants). Employees like them because they represent an opportunity to grow wealth, with tax consequences deferred until the year of exercise.
How you get them
Nonqualified options are usually granted pursuant to a stock option plan that was adopted by the company’s board of directors and approved by the shareholders. The board of directors, or a committee appointed by the board (usually called the compensation committee), may decide who receives the awards and the specific terms of the options. In some cases options are granted according to a formula.
What you’ll receive
When a company grants an option it should provide certain documents. You should receive an option agreement, setting forth the specific terms of your option. If the option is issued under a plan, you should also receive a copy of the plan (or at least access to a copy of the plan), which provides some general rules that govern all options. In many cases the company also provides a summary of the plan.
It’s important to understand your rights under the agreement and the plan. You need to know:
- What is the earliest date you can exercise the option? Does it become exercisable in stages?
- What do you need to do when you exercise the option? Is cashless exercise available? Can you exercise using stock you own?
- When will the option terminate? Can you exercise after your employment terminates? What if you die while holding the option?
Make sure you keep these documents in a safe place. Be sure to review them from time to time for planning purposes. At a minimum, you want to think about your options before the end of each year to determine whether to exercise some or all of the options by December 31 as part of your tax planning.
Here are some of the important terms used in connection with nonqualified options:
- You receive the option when the company makes a grant or award.
- You exercise an option when you take the action specified in the option agreement to buy the stock. Usually you have to fill out a form notifying the company that you are exercising the option and provide cash equal to the purchase price (and possibly cash to cover any withholding obligation).
- The exercise price (also called the strike price) is the amount you have to pay to purchase the stock.
- The bargain element (also called the spread) is the difference between the value of the stock and the exercise price. For example, if the value of the stock is $24 and the exercise price is $19, the spread is $5. When the spread is a positive number, the option is in the money.
- Options are under water (or out of the money) if the exercise price is higher than the value of the stock. There is no particular tax significance to an option being under water, but the practical significance is that you will not be in a position to profit from exercising your option until the price of the stock recovers.
Companies have great flexibility in the terms they can offer for nonqualified options. Your option may differ from the typical option in a number of important ways. But it may be helpful to compare your option with the norm:
- The exercise price is usually set at (or near) the value of the stock at the time the option is granted.
- The option becomes exercisable over a period of several years.
- Cash payment is usually required at the time of exercise, but some companies make a form of “cashless exercise” available, and others will loan the money needed to exercise the option.
- The option expires ten years after it was issued, or earlier if employment terminates. You may or may not have an opportunity to exercise options that are already vested (exercisable) at the time employment terminates. Options that are not exercisable at that time typically expire.