In the minds of most Americans, the term "stock option" is associated with the executive suite. It connotes a special perk for senior management, a way corporations can help their rich bosses get richer.
But at a growing number of companies, stock options are moving out of the corner office and onto the shop floor, the receptionist's desk, the loading dock. Workers who sometimes hardly know the difference between a stock and a bond are now being granted options that over a period of years could be worth twice the value of their ordinary pay.
The granting of options to rank-and-file workers makes sense for many reasons, firms and benefits experts say. And while there are many stories of high-technology start-ups giving them because they can't afford cash wages, some big, established firms are using them as well.
"The most important thing they are trying to do is attract and retain good people," said Corey Rosen, executive director of the National Center for Employee Ownership, a nonprofit information and education group based in Oakland. "That's not just an issue when you're looking for software designers. Labor markets are tight and are projected to continue to be tight" in many fields.
A stock option is the right to buy a share of stock at a preset price. If the stock rises above that price, the option holder thus can buy it at a discount. And in cases where the company stock has soared, that can be a real windfall.
Of course, if the stock falls and is trading below the option price, the option has no value. Thus, options give employees a stake in the company's stock market performance, aligning their interests with those of general shareholders.
The use of stock options has "grown exponentially," Rosen said. A survey by his group found that in 1992, about 1 million U.S. workers were employed by firms that offered options to most or all employees. By last year the figure was 7 million, "and we're sure that it's more now," he said.
Many workers, though, are missing out on some or all of the benefits of the options they receive because they don't really understand how they work. These errors can have adverse tax consequences or, more commonly, cause the worker to miss out on a major portion of the value options have to offer.
"There are abundant stories, [such as] the $40,000 sofa," said Mike Butler, managing consultant in the Rowayton, Conn., office of Hewitt Associates, a benefits consulting firm.
In the $40,000 sofa story, a worker is granted options, exercises them at the first opportunity and uses the money to buy living-room furniture. A year or two later he hears colleagues talking about all the money they made by holding their options longer as the company stock rose, and he realizes "that sofa cost me $40,000," Butler said.
"You hear stories like that all the time," he said.
Thus, if your company gives stock options, it's wise to find out all you can about options generally, and your company's program in particular.
The first step, Butler said, is to find out what you have to do to get the options. At some firms, options "are spread like peanut butter--everybody gets some"--but in a lot of cases there are performance targets, so "learn the rules of the road," he said.
One of those rules is the "vesting period," the time between the grant of the option by the company and when it can be exercised. Vesting periods of two or three years are common.
Next, if you are in line to receive options, you want to know what kind. Options come in two types: non-qualified stock options (NSOs) and incentive stock options (ISOs), with different rules and different tax treatment.
Currently, NSOs are the more common type. Employees who get them aren't treated as well tax-wise, but the option grant is deductible to the company.
With an NSO, the option is not taxable when granted to you, but when you exercise it you are taxed on the difference between the option's exercise price and the market price of the stock. Thus, if the option allows you to buy stock at $100 a share and the stock is trading at $150, you are taxed on the $50. The tax is at ordinary income rates, but if you hold the stock and sell it later, you pay tax at capital gains rates on any subsequent appreciation.
You don't have to come up with any money when the option is granted or while it is outstanding, but when you exercise the option you generally do have to come up with the money to buy the stock at the option price and pay the taxes. Some companies arrange for cashless deals in which a broker buys the stock and immediately sells it, giving the worker the difference between the exercise price and the market price, minus taxes.
With an ISO, by contrast, there is no tax to you when the option is granted or when you exercise it. And if you do not sell the stock within two years of the grant of the option and hold it for 18 months after exercising the option, your gain is taxed at capital gains rates.
Companies choose between ISOs and NSOs based on the demographics of their work force and their own economic situations, Rosen said. "If workers primarily . . . will be in higher income brackets once they exercise the options, it's a benefit for them to do an ISO," he said. In a rapid growth phase of a start-up company, where there is little profit, "the NSO deduction isn't there anyway," Rosen said, "so they might as well give the advantage to the employees."
In addition, Butler noted, the difference between capital gains and ordinary income rates has been relatively modest until recently. Now that new lower capital gains rates have widened the differential, ISOs are gaining, he said.
"ISOs basically exist to leverage the differential between capital gains and ordinary income rates," he said. ". . . An ISO is very much a creature of the tax code."
Experts say the biggest pitfall with stock options is exercising them too soon.
Jane Romweber of Hewitt Associates notes that options are a form of leverage--as the stock appreciates while you hold the option, you are compounding off the full pretax face value of the option. If you exercise the option, buy the stock, and pay taxes, your holdings would continue to rise but you would be compounding off a much lower base.
Suppose you had $100,000 in non-qualified options--say, the right to buy 1,000 shares at $100 a share--on a stock that is growing at 10 percent a year.
Romweber figures those options would grow to $133,100 over three years. If you exercised then, you would net $19,860--$133,100 minus the $100,000 exercise price minus $13,240 in taxes. That amount, even if you invested it in something appreciating at 15 percent a year, would grow only to $46,233 after tax over the next seven years.
On the other hand, if you held the options seven more years, to their full 10-year life, they would grow to $259,374. When exercised, they would net you $95,624--$259,374 minus the $100,000 exercise price minus $63,750 in taxes.
Obviously, with a very volatile stock, or a company with dubious prospects, selling early may be better, but in solid companies with upward-trending stocks, holding the option until the last minute is usually the best strategy, she said.
Another pitfall with ISOs is selling before the holding period is up, in which case the option "defaults to an NSO" and you lose your tax benefit, Rosen said. He added that some companies grant ISOs knowing that many employees will make that mistake, thus allowing the company to reward financially sophisticated workers at less cost to itself.
Stock options are a bonanza for a worker who is both lucky and careful, but their complexity is a real problem. Some companies do a good job of explaining them, but many do not. If you are in line to get options or think you might be, it's a good time to get professional advice. A financial planner or accountant will cost something, but probably not nearly as much as doing the wrong thing.
Opting for Stock Options
Cashing out early on stock options can be a costly mistake. This is because the original face value of the stock, as well as the accumulated gains, are working for the stockholder who continues to hold. Consider this:
Say that Mary and Ruth each get stock options worth $100,000 in 1999. Assume the stock gets a 10 percent annual return, and the money invested from exercised options earns 15 percent. Here is the $49,391 difference:
Mary cashes out after three years, in 2002. She gets $133,100 ($100,000 compounded over three years at 10 percent annually.
After subtracting the initial $100,000 exercise price and $13,240 in taxes, she has $19,860. She invests that (at the 15 percent annual return) over the next seven years ($52,828, and pays $6,595 in capital gains taxes). Bottom line: $46,233.
Ruth waits 10 years, until 2009, to exercise her stock options. She gets $259,374 ($100,000 compounded over 10 years at 10 percent).
After subtracting her $100,000 exercise price and $63,750 in taxes, her total is $95,624.
Premium for holding the stock options: $49,391
SOURCE: Hewitt Associates