Stock options or awards can be quite complex. The goal of Employee Stock Options Explained is to provide employees with a complete primer to their stock options. Simple explanations so you have the tools to begin to manage your stock options. Employer stock may be a significant part of your net worth, which is why it’s so important to partner with professionals who can help you make the right decisions for your individual situation and goals.

Stock Options Explained

To maximize the benefit of stock options or awards, you’ll need to have an integrated strategy that can help you diversify your investments, while taking into account the tax implications and other financial planning considerations.

Understanding your employee stock options or equity awards

Key employee stock option terminology


  • Exercise price (or the strike price). The exercise price is the price you’re able to buy the shares. This price is set in advance and doesn’t change.
  • Fair market value (or FMV). Fair market value is the price of a share of company stock in the open market. If publicly traded, the price on a public stock exchange. If the company is private, a valuation firm will periodically conduct a FMV analysis. The fair market value of public company stock changes all the time.
  • In-the-money. When a stock option is “in-the-money” or “above water” the strike price is less than the fair market value of the shares. Here’s an example: if your exercise price is $5 and the stock is trading for $10, it’s “in-the-money.”
  • Out-of-the-money. When a stock option is “out-of-the-money” or “underwater,” the strike price is more than the fair market value of the shares. Using the previous example, if the stock was trading for $4 not $10, it would be “underwater”.
  • Vesting schedule. A vesting schedule is provided along with your stock option or equity award agreement. It provides key dates for exercising, vesting, strike price, and number of shares in the grant. Vesting is so important. It dictates when you earn the right to buy the stock or receive shares.

Stock Options Explained ISOs and NSOs

What type of employee stock options do you have?

Companies grant two kinds of stock options:


Restricted stock units (RSUs) aren’t stock options – they’re equity awards

The difference isn’t just semantics either. Unlike stock options – which require the employee to purchase the option at the strike price – restricted stock units are just given to employees as equity awards, typically upon vesting. So unlike stock options which can become “underwater” if the market price is less than your purchase price, RSUs always have some value unless the stock goes to zero. Obviously, at that point, you would have other issues to contend with.


Private companies typically have a time-based vesting requirement in conjunction with an event-based requirement, such as an IPO, funding, or an acquisition for liquidityWhen RSUs vest they become common stock. The value of your equity grant will be determined by the current market value on the vesting date.

Restricted stock awards (RSAs) are another common type of equity-based compensation


For restricted stock awards to yield any value, employees must first satisfy the vesting requirements, which may be time or performance based. RSAs allow employees to make a choice about when to pay income tax on the award – called an 83(b) tax election. Although very similar to restricted stock units, restricted stock awards are not the same thing.

How are stock options taxed?

Tax treatment of incentive stock options (ISOs)


So although incentive stock options do have tax benefits if you satisfy the holding period requirements (at least two years from the date of grant and one year from the date of exercise), in many situations it still may not be advantageous to do so. The AMT and the risk the options may become underwater are two driving factors. This infographic has more on the taxation of incentive stock options.

Taxation of non-qualified stock options (NQSOs)


Tax treatment of restricted stock units (RSUs)



Taxation of restricted stock


Default taxation of restricted stock awards

No tax is due when the grant is accepted. At vesting, the difference between the fair market value and the amount you paid for the shares is ordinary income. If you sell the shares immediately, there are no other tax consequences. If you hold the stock, any further gain or loss after vesting is considered a capital gain or loss when you sell the shares.

Whether you’ll have a short or long term capital gain/loss depends on your holding period. More than one year is long-term, anything less is short-term. Short-term capital gains rates are essentially the same as regular income.

83(b) tax election

An 83(b) tax election allows restricted stock award recipients to pay ordinary income tax on the award before it vests. The portion of ordinary income is the difference between the fair market value of the stock at grant and what you pay for the shares. Any additional gain or loss after the shares vest is a long-term capital gain or loss. You’ll pay the tax in the year you sell the stock. This article has more on restricted stock.

How stock options work

Other ways employees own company stock

  • Employee stock purchase plan (ESPP): Section 423 employee stock purchase plans allow you to buy shares of your company’s stock, typically at a reduction of 5% to 15% compared to the market price. ESPP accounts will withhold a portion of pay through regular payroll deductions, up to $25,000 per year. The ESPP plan buys the stock a few times a year, semi-annually or quarterly usually.
  • Employer stock in your retirement plan: According to Bloomberg’s ranking of retirement plans, in 2014, one in five of the largest companies in the S&P 500 made 401(k) contributions in company stock. Owning too much company stock in always a risk. But when the shares are in your retirement plan, it can have devastating effects. While you can’t control whether your employer matches in cash or stock, you can control the asset allocation for your contributions.

Can you have too much company stock?

In a word: yes. And most people do. How much you should invest in employee stock options and company stock depends on your assets and risk tolerance. In general, don’t tie up more than 10% of your net worth in your employer’s stock.


Managing concentrated stock positions and how to diversify

How to diversify out of a concentrated stock position depends on your individual situation. But in general terms, there are several ways employees can reduce their concentration in employer stock:

  • If your employer matches retirement plan contributions in shares of company stock, you may be able to diversify right away. Most companies who match only in employer stock allow sales immediately. Read your retirement plan documents for more information.
  • If you’re receiving stock options or RSUs, you may reconsider participating in an employee stock purchase plan. You can’t control your grants, but buying shares in an ESPP is optional.
  • If your company stock is a big part of your compensation and net worth, consider working with a financial advisor and CPA to develop a plan to systematically liquidate and diversify your positions. This doesn’t always mean selling everything, either. By developing a systematic diversification strategy integrated with your entire financial life, you can help ensure you’re making the most of your stock options. Advisors can help keep an eye on potential tax consequences and your overall risk exposure.

Treatment of stock options if you quit, retire, are fired, are laid off, or otherwise leave the company

Several factors impact whether you can keep your stock options, RSUs, or other stock compensation after changing jobs. It may be a surprise that the reason for your departure can impact the outcome for your stock. 

Other key factors include: 

  • Whether your shares are vested and whether or not you’ve exercised
  • What type of equity compensation you have? (e.g. stock options, restricted stock units, employee stock purchase plan, stock appreciation rights, phantom stock)
  • Whether your employer is public or private
  • Why you’re leaving the company (retirement, a new job, laid off, terminated with/without cause)

Termination for cause will typically result in cancelling vested or unvested options that haven’t been exercised. But if you leave for another reason, you may still be able to exercise your vested options. In most plans, RSUs, and stock appreciation rights (SARs) shares of stock or settled in cash upon vesting.

If you leave before vesting, you will likely lose your equity compensation. This article has more on what happens to your stock options when you leave the company.

What happens to employee stock options after an IPO?

Do you have stock in a private company planning to go public? Pre-IPO companies use valuation experts to value the stock. The company needs a system in place for employees to sell their shares. If your company is planning on going public in the near future, this can be both good and bad news.

An IPO is good because you will (eventually) be able to sell your shares after exercise on a public exchange. Going public could add new risk because of the lock-up period. After the IPO, insiders like employees can’t sell their shares right away. The lock-up or blackout period ranges from 90 to 180 days.  

What may happen after your company goes public will depend on a number of factors, such as whether you have stock options or restricted stock units at a pre-IPO companyNot all IPOs are successful. Sometimes, they never even get off the ground. Learn what can happen to your stock options after a failed IPO.

What it means for your stock options if your company is bought by another firm

Unfortunately, there is really no concrete answer for this question. What can happen will be determined by a number of factors: for example, are your options vested or unvested? Have you exercised the options? Is your company public? Is your company selling to a private firm?

Understanding RSUs

What happens to restricted stock units or awards after an acquisition?

What can happen to restricted stock units after a company sells or merges will depend on several factors. It isn’t always about money either. If the acquiring firm doesn’t give current employees stock options, it may not want to.

The terms of the deal play a large role too. Is your company is being sold in an all cash deal, all stock, or blend of the two? This podcast on what happens to RSUs after a merger or acquisition has more information.

Managing stock options can be difficult, especially with a busy schedule. When developing a strategy for your equity compensation, make sure it is integrated with the rest of your investment strategy. Financial planning can’t happen in a vacuum! If you need help or want to speak with an advisor about your personal situation, please contact us today.

Download our Guide to Managing Stock Options or Guide to Managing Restricted Stock Units

Darrow Wealth Management offers comprehensive wealth management services to individuals and families. To learn more about working with a fee-only financial advisor and full-time fiduciary, schedule a consultation with one of our CFP® professionals.

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