What Are Stock Options and How Do They Work?

Written by: Will Holt

If you’ve been offered stock options, you’ve probably wondered how you should best handle them.

This starts with understanding what they are and the rules and regulations around exercising and selling them.

Why Do Companies Use Stock Options?

Companies use stock options as a part of a compensation package to reward, retain and attract talented employees. This form of compensation pays the employee in company stock rather than cash. The idea is to align the company and employee’s goals by giving the employee an ownership stake.

The employee is incentivized to increase their productivity which filters into the company’s bottom line. Everyone is motivated to increase the company’s stock price.

Rules and Regulations to Be Aware Of

The rules and regulations around stock options are complex. An entire industry of financial experts, legal professionals and tax practitioners has grown to provide advice to the executives and other high-level employees who receive stock options.

careful approach to managing the ins and outs of stock options is warranted, as failure to follow the rules can not only be expensive but can also create legal issues.

Watch the Insider Trading Rules

The Securities and Exchange Commission views the detection and enforcement of insider trading violations as one of its main functionsInsider trading rules prohibit trading a company’s stock if the person has access to material nonpublic information. Corporate officers and other key employees are at risk of violating insider trading rules because of their position within the company.

To mitigate this risk, companies will adopt insider trading policies and compliance programs.  The common components of these programs include trading windows, blackout periods and pre-approval of trading activities. SEC rule 10b5-1 allows executives and other employees who may be considered insiders to establish advance trading plans which provide protection against violations.

Should I Worry About a 10b5-1 Plan?

10b5-1 plan can be designed with flexibility in mind to fit the goals of the stock option grantee.  Maybe college tuition or a down payment on a home is on the horizon. A liquidity event plan can be put together that will sell shares if a higher stock price is achieved or sell at a lower price if the time limit is expiring.

Diversification away from a concentrated position in the company stock is a common goal. A good option is to use a plan that will sell a certain number of shares on a regular basis at a price that the grantee is comfortable with. Tax efficiency is a key consideration and requires an understanding of which shares are better candidates to sell than others.

Related: Should You Use a Non-Qualified Deferred-compensation Plan For Your Retirement Savings?