When you get hired at a startup company you’ll often receive stock options as part of you compensation package. If you’re lucky your grant will include ISOs. Once vested, you can exercise your options and buy shares of stock at the strike price instead of the current fair market value. This bargain element provides an instant economic benefit, but also puts your money at risk and can create AMT implications. When your company IPOs and the lock-up period has expired you’ll be able to sell your stock and hopefully make a small (or large) fortune.

Simple and understandable, right? Probably not.

If you work at a startup company you've heard the above narrative before. In fact, it was probably a big reason for accepting the job in the first place. We’ve all heard the stories of stock options making Silicon Valley employees rich, but few truly understand how they work until it’s too late. As a result you could end up paying more in taxes and leaving a lot of money on the table. With a basic understanding and proper planning you can easily put yourself in a better position. In future posts I’ll teach you some of the inner-workings of stock options and most importantly how to maximize your profit while minimizing risk and taxes.

Before we can get to the “fun” stuff, we first must understand the language. You have probably heard most the italicized terms in the opening narrative, but I doubt you fully understand what they all mean. Let’s break it down…

Stock Option: A stock option simply gives you (the option holder) the right to purchase shares of stock in the future at a pre-determined price after certain requirements have been met. The stock option itself does not give you equity in the company—it merely gives you the right to acquire it.

Grant: When your employer “gives” you stock options it is called a grant. The details of your grant are outlined in an option agreement. The option agreement will specify the number of shares you can buy, when you can buy them (vesting), and for how much you can buy them (strike price).

Incentive Stock Option (ISO): An Incentive Stock Option is a type of stock option that meets certain requirements and therefore is eligible for special tax treatment. Anything other than an ISO is called a non-qualified stock option, often shortened to NQSO or “non-qual.”

Vesting: Contained in your option agreement will be a vesting schedule which dictates when you become eligible to purchase shares of stock (i.e. exercise your option). As an example, when hired you might be granted an option to buy 4,800 shares of stock, vesting over the next four years. At the one-year anniversary you will be eligible to purchase 25% of the stock (1,200 shares). Thereafter you will vest at a rate of 100 shares per month for the next three years until you are fully vested.

Strike Price: The strike price (also referred to as the grant price, exercise price, or option price) is the price you may purchase shares of stock for under your option agreement. Usually the strike price is the fair market value per share of stock at the time of grant. Assuming the value of the company increases after the grant, your strike price will be lower than the fair market value at time of exercise, thus allowing you to buy the stock at a “discount.”

Fair Market Value (FMV): The fair market value of a company's stock is critically important to your planning process. It determines both your strike price (FMV at time of grant) and your bargain element (defined below) which in turn affects your risk exposure and tax liability. Determining the FMV of a private company is beyond the scope of this post, however most of the time an appropriate FMV will be given to you by your company. Once the company goes public, determining FMV will be easy as it’ll simply be the price at which it trades on the public market.

Bargain Element: The bargain element is the difference between the current FMV and your strike price. It represent the economic value of your stock option. If the current FMV of your company’s stock is $10 per share and your strike price is $2 per share, the bargain element is $8 per share. The bargain element is also commonly referred to as the spread.

Alternative Minimum Tax (AMT): The AMT is a separate (think parallel) tax system to the “regular” tax system. Every year you pay whichever tax calculates to a higher amount (fun, huh?). Unless you own a home, have lots of itemized deductions, or have previously exercised ISOs there is a good chance you have never had to pay AMT and perhaps that you didn’t even know it existed. However, if you are going to exercise ISOs it is imperative that you consider the implications of AMT or you could get caught underpaying your taxes, which would result in penalties and interest (definitely not fun!). We’ll get into this more in future posts.

Initial Public Offering (IPO): An IPO is one of the most exciting days for employees and investors. It represents the first time company stock is offered to the public and begins trading on the open market. The reason this is important to you is that it gives you the ability to sell your stock (hopefully at an appreciated price) and diversify into a long-term portfolio. Think of it as an opportunity to harvest all the energy and value that you’ve put into the company.

Lock-up Period: Not so fast! Although everyone else gets buy/sell after the IPO, most employees and insiders will probably be “locked-up” and unable to sell for six months after the IPO. This can be a very volatile period for the newly public stock and your emotions will likely follow in lock-step as the stock hits new highs and lows.

Now that we’ve defined and explained the jargon that is so often thrown around with stock options, re-read the narrative at the beginning of this post and see if it makes any more sense. Understanding these elements will be important as we delve deeper into stock option planning and strategies. Stay tuned for future posts!