How do Incentive Stock Options (ISOs) work?



When I was hired, I was granted 1,000 ISO stock options. I have vested 500 and have not exercised any because I don’t really understand the implications of exercising them. What happens to the money I spend on them? What is the potential gain? What are the risks?

In: Economics

So the options give you the option (hence the name) to purchase stock at some point in or period of time at a set price no matter what the current stock price is, once they’ve vested.

So if you have vested options to purchase 500 shares, at say $50 per share, and the stock price is at $100, you can purchase the shares for $25,000 and immediately have $50,000 worth of stock that you can sell or keep.

Keep in mind that there are tax considerations associated with exercising options that aren’t obvious so I highly recommend speaking with your tax advisor before making any decisions about what to do.

For your specific questions:

The money goes to your employer, and they hopefully give you more valuable shares in return.

The immediate potential gain is the difference between the current stock price and the exercise price of the options. The options can be held until their expiration, though this gain may change over that time.

The risks are changes to the stock price before or after exercising. There are also some tax considerations (taxes are due when you sell things and exercising is generally considered similar to a sale).

ISOs are like coupons to be used to pay for discounted shares of stock.

Let’s say the current stock price is $10 and your ISO discount or strike price is $5. When you exercise an option, you pay $5 to get something that is worth $10. If you sell it immediately, you get your $5 invested and $5 profit. However, that $5 profit will be taxed as income.

If you hold the exercised share for at least 2 years before selling, the profit will be taxed at the capital gains rate which is lower than the income tax rate.

The risk is that the stock ends up at a lower price than your strike price so it’s not worth using the options. These options also expire usually 10 years after the grant date. They may also be taken back if you leave the company. The stock may also lower after you exercised the options and hold on to stock.

These incentives help employees focus on working to build the company’s worth so the stock and thus the value of the ISOs goes up.

A stock option lets you buy the stock at a fixed price below market rate.

If it’s a public company, you could then sell the stock and make the delta between your buy price and the market price of the stock. It’s basically extra compensation in a public company if the stock is stable or trending up.

If it’s a private company that hasn’t IPO’d or been acquired, you might wonder why they matter if you can’t exercise them. If you leave the company, you lose the options – but you keep any options you exercise.

There already also tax implications – if you have options that aren’t worth much now but you anticipate them to be a lot in the future, it can make sense to exercise and hold. If you sell within 2 years it’s a short term gain and taxed like regular income. If you hold longer than that, it’s taxed as long term at a lower rate.

In most cases you’ll want to buy them if the company is healthy (and if it isn’t, you probably want to find a new gig anyways).