startup stock options explained

Understanding Your Stock Options

The CES Group at Morgan Stanley

© 2013 Morgan Stanley Smith Barney LLC. Member SIPC.

Yesware Presentation SeriesJuly 17th, 2014

Agenda• Stock Ownership

• Basics of Stock Options

• Types of Stock Options

• Exercise Methods Provided by Plans

• Exercise Decisions

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THE CES GROUP 1650 Market Street, Floor 42

Philadelphia, PA 19103

(215) 963-3853

• Jacob Guzman, Corporate Client Group Director, Vice PresidentMorgan Stanley

• Robert Biggs, Executive Financial Services Director, Vice President Morgan Stanley

• David Charton, Financial Advisor, Portfolio Manager Morgan Stanley

Presenter Information

Basics of Stock Options

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• Exercise – The purchase of shares underlying an option.

• Fair Market Value / Market Place / Current Trading Price– For tax and accounting purposes, the value of a share of stock on any given date. In a

public company, fair market value is determined with reference to the price posted on the applicable stock market.

• Grant – The act of awarding stock options by a company to its employees.

• Grant Price / Exercise Price – The purchase price per share as set forth in your stock option agreement or option

grant document.

• Grant Expiration Date– A date, predetermined by the company, on which your option grant will expire and the

option can no longer be exercised.– Acceleration of the expiration of your grant may occur upon certain events, like your

termination from the company. Please consult your grant agreement or plan documents for specific details.

Glossary of Terms for Stock Options

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• Option Shares– The specific number of shares granted in relation to the option.

• Important Note: an option is a right to buy shares; it is not a share of stock.

• Share of Stock– Represents ownership in a company.– Trades on an exchange.

• Stock Options– The right, or option, to purchase company stock for a specified period of time at a

specified price (grant / strike / exercise price).

• Vesting Schedule– Time at which portions of the option grant become available for exercise. Vesting schedules

may be staggered with a portion of the grant vesting over a given time frame (e.g., 25% vests each year from grant date) or all the options can vest at once (e.g., 100% vests one year from grant date). Only when an option has “vested” is it available for exercise.

Glossary of Terms for Stock Options (cont’d)

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3-Year Cliff Vesting Schedule

Year3

All 450 shares are vested / exercisable

Grantdate

For illustrative purposes only.

450 stock option grant, 100% vesting after three ye ars

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4-Year Graded Vesting Schedule


100 stock option grant, 25% vesting each year

25 shares are vested / exercisable

Year1

Year2

Year3

Year4

25 more shares are vested / exercisable



Grantdate

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Grant Price vs. Current Trading Price


Current trading price at time of exercise

Stock Price

Grant Price (FMV on grant date, price that shares are exercised at)

$6 spread at exercise before any taxes, commissions and applicable fees

$25

$19

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Grant Price vs. Current Trading Price


Option has no positive spread (“under water”)

$15

$19$4 Decline fromGrant PriceGrant Price (FMV on

grant date, price that shares are exercised at)

Exercise will not be allowed since the option is “under water”

Stock Price

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In the Money or Out of the Money?


• Intrinsic value is the difference between exercise or strike price of an option and the market value of your company’s common stock

Example: 100 shares with a grant price of $10 per share

$10 Grant price $5 intrinsic value ⇒options are $500 “in

the money”

$5 trading price at a future date

$0 intrinsic value ⇒options are “out of the

money” or “underwater”

$15 trading price at a future date

$10 Grant price

Types of Stock Options

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• The difference between the strike price and the market value (“spread”) is taxed as ordinary income at the time of exercise.

• Appreciation on stock held after exercise is taxed as a capital gain.– Stock sold in 12 months or less from exercise date is short-term capital gain or

capital loss.– Stock sold more than 12 months after exercise date is long-term capital gain or

capital loss.– Cost basis is stock price at time of exercise.

Non-qualified Stock Options (NQSOs)

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• Can only be granted to employees of a company.

• Tax withholding on the gain is not required at the time of exercise, although may be owed at year-end.

• Spread at exercise may be subject to Alternative Minimum Tax (AMT).*

• Long-term capital gain treatment (or capital loss) on stock sale if the holding period is met:– Holding period is 2 years from grant and one year from exercise.– Tax treatment changes when ISO stock is not held for required period (spread is

reported as ordinary income) resulting in a disqualifying disposition.– Cost basis is equal to grant price.

*Morgan Stanley Smith Barney LLC and its affiliates do not provide tax or legal advice. To the extent that this material or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

Incentive Stock Options (ISOs)

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• Required holding period is 2 years from grant, and one year from exercise.

• When stock is sold before the end of the holding period:– Capital gain is converted to taxable compensation.– Alternative Minimum Tax (AMT)* is eliminated for shares sold in same calendar

year as exercise.


Disqualifying Disposition for ISOs

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• For ISOs, the spread at exercise may be subject to AMT.*

• For individuals who have utilized specific tax deductions and expenses in excess of certain stated limits.

• Compare regular income tax with AMT* calculation, and pay the higher of the two tax liabilities.


Alternative Minimum Tax

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• An ISO grant’s fair market value within the calendar year that it becomes exercisable cannot exceed $100,000.

• Any ISO grant(s) that exceed the $100,000 limit are considered NQSOs (non-qualified stock options) and are subject to taxation at exercise. The split occurs at the time of the option(s) are granted; not at the time the participant exercises the option(s).

• The ISO grant value is determined by multiplying grant price by the number of vested options.

$100,000 Limit on ISOs

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Example of ISO Limit

Employee A

• Receives 12,000 ISOs with a grant price of $20.

• 3,000 options vest in first year.

• 3,000 x $20 = $60,000.

• Within the $100,000 limit.

Employee B

• Receives 12,000 ISOs with a grant price of $20.

• 3,000 options vest in first year.

• 3,000 x $20 = $60,000.

• Receive another grant:

– 12,000 ISOs received with a grant price of $15.

– 3,000 x $15 = $45,000 vested.

• $60,000 + $45,000 = $105,000 vested in same year.

• X number of shares from the second grant (equal to $5,000) treated as NQSOs.


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Tax Treatment for ISOs vs. NQSOs

Spread at Exercise Stock Appreciation

Incentive Stock Options May be subject to Alternative Minimum Tax (Qualifying Disposition)

Capital GainCost basis = Grant Price

Disqualifying Disposition – ISOs

Taxable compensation, taxes paid with estimated tax payments or with income tax return

Short- or long-term capital gain, (early stock sale) depending on holding period

Non-qualified Stock Options

Payroll tax withholdings, ordinary income

Short or long-term capital gain depending on holding period, Cost basis = fair market value at exercise

Morgan Stanley Smith Barney LLC and its affiliates do not provide tax or legal advice. To the extent that this material or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

Exercise Methods Provided by Plan

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Hypothetical Example: Exercise and Hold (NQSOs)

Exercise and Hold

• Pay out of pocket: grant price (option cost) + taxes and any applicable fees.

• Receive the stock and hold as an investment.

1 Does not include transaction fees.For illustrative purposes only.

100 Share Exercise – Sample Market Price = $25.00Exercise and Hold (1)

($)

Fair Market Value at Exercise (@ $25.00 per share) 2,500

Option Cost (@ $19.00 per share) 1,900

Spread at Exercise (@ $6.00 per share) 600

Total Taxes (for example – Federal, State, Local, Employee) (231.90)

Amount due from participant (option cost @ $1900 + taxes 231.90) (2,131.90)

100 shares x the current market price of $25.00 2,500

Cost Basis on Held Shares = $25

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Hypothetical Example: Exercise and Hold (ISOs)


100 Share ExerciseExercise and Hold (1)

($)

Fair Market Value at Exercise (@ $25.00 per share) 2,500

Option Cost (@ $19.00 per share) 1,900

Spread at Exercise (@ $6.00 per share) 600

Total Taxes (for example – Federal, State, Local, Employee) (0)

Amount due from participant (option cost @ $19 x 100 Shares) (1,900)

100 shares x the current market price of $25.00 2,500

Cost Basis on Held Shares = $19

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• Exercising your options and selling enough shares of resulting stock to cover the cost of the option exercise, plus taxes, commissions and applicable fees.

• A form of cashless exercise.

• Receive the balance of stock as an investment to hold.

• Cost basis on held shares = current trading price of the stock at the time of exercise for NQSO.

Exercise and Sell to Cover

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Hypothetical Example: Exercise and Sell to Cover (NQSOs)


100 Share ExerciseExercise and Sell to Cover (1)

($)

Market Value at Stock Sale 2,500

Option Cost 1,900

Spread at Exercise 600

Total Taxes (231.90)

Options Cost + Taxes ($1900 + 231.90) (2,131.90)

Shares Sold to Cover

Option Cost +Taxes ($2,131.90 / $25) 86

Cash Left Over 18.10

Shares Deposited to Your Account 14 shares valued at $350.00

Cost Basis on Remaining Shares = $25

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Hypothetical Example: Exercise and Sell to Cover (ISOs)


100 Share ExerciseExercise and Sell to Cover (1)

($)

Value at Stock Sale (Fair Market Value = $25) 2,500

Option Cost 1,900

Spread at Exercise 600

Federal Income Tax 0

State / Local Tax 0

Total Taxes 0

Shares Sold to Cover (Option Cost / $25) 76

Cash Left Over 0

Shares Deposited to Your Account 24 shares valued at $600.00

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• Form of “cashless exercise” or “same-day sale.”

• Simultaneously exercise option and sell stock proceeds.

• Receive a cash payment for the difference between the option price and the price at which the stock was sold, less taxes, commissions and applicable fees.

Exercise and Sell All

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Hypothetical Example: Exercise and Sell All (NQSOs)


100 Share ExerciseExercise and Sell (1)

($)

Market Value at Stock Sale ($25 x 100 Shares) 2,500

Option Cost ($19 x 100 shares) 1,900

Spread at Exercise ($6 x 100 Shares) 600

Federal Withholding @ 28% (168.00)

State / Local Tax @ 3% (18.00)

Social Security Tax @ 6.2% (37.20)

Medicare Tax @ 1.45% (8.70)

Total Taxes (231.90)

Net Proceeds ($600 – $231.90) 368.10

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Hypothetical Example: Exercise and Sell All (ISOs)


100 Share ExerciseExercise and Sell (1)

($)

Market Value at Stock Sale ($25 x 100 Shares) 2,500

Option Cost ($19 x 100 shares) 1,900

Spread at Exercise ($6 x 100 Shares) 600

Federal Income Tax @ 28% (168)

State / Local Tax @ 3% (18)

Total Taxes (186)

Net Proceeds 414 (600 – 186)

Remaining Shares 0

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• This is a branch-handled transaction where you use shares of company stock you already own to pay for the exercise of options.

• Additional shares received = spread at exercise.

• Market value of additional shares becomes taxable compensation; Example: 24 additional shares with a current trading price of $25 per share = taxable compensation of $600.

Stock Swap Exercise

Example: 100 options, grant price $19, Market value $25

Turn over 76 owned shares to exercise 100 options,Receive 100 shares of stock: 24 additional shares

76 shares

100 shares


Exercise Decisions

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• Do you believe the stock price will give you favorable returns?

• What are your tax issues?

• What are the specifics of your plan?

• What is your funding situation? Are you able to pay the option costs out of pocket?

• Are you comfortable carrying the market risk that comes with owning stock?

Various Issues in Exercising Options

Note: Morgan Stanley can not advise you on whether or not to exercise your stock options.

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• Market Order: An order to buy or sell a specified number of shares at a price close to the current market price. – Executed at whatever price is available when your order reaches trading floor.– Generally, the order is guaranteed to be filled.

• Limit Order: An order to sell a stated amount of shares at a specific price.– Exercise will not occur if stock does not reach limit price.– Limit orders will be good until cancelled (GTC) and will expire one year from the

order entry date.– A cancellation of an existing order can be requested by participant or can occur

due to the Company’s Plan Rules or because the GTC order has expired.

Market Order or Limit Order?

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• You will receive the information necessary to access your plan account information online.

• You will receive either:– A ‘BAMail,’ a Benefit Access email containing a personal URL. This URL links

you to the site to customize your User Name and Password.OR– A hard copy Internet welcome letter that contains your temporary User Name and

Trading PIN. You will receive separate a mailing 2 days later with your temporary Internet Password. Use your temporary User Name and Password to log onto www.benefitaccess.com

– Once you login using your temporary credentials, you can customize your User Name and Password.

Internet Activation

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www.benefitaccess.com

• View account information in various ways.

• Model transactions:– Determine Your Proceeds. – Determine How Many Options to

Exercise.– Determine the Cost of Holding

Shares.– Holding Shares with No Cash

Outlay.

• Execute trades in real-time (Market Orders or Limit Orders)/Exercise & Sell to Cover Orders.

• Access online tutorials and trading simulators.


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• Available Monday through Friday, 22 hours a day.– System closed for maintenance for 2 hours anytime between 10:00 p.m. and

2:00 a.m. ET.

• Access real time quotes during market hours.

• Place a real-time market or limit order.– Market Order: Buy or sell a specified number of shares at a price close to the

current market price.– Limit Order: Sell a stated amount of shares at a specific price.

• Review recent transactions.

• Customize your IVR trading PIN.

Interactive Voice Response (IVR)

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• Service Professionals are available Monday through Friday, 8:00 a.m.–8:00 p.m. ET on market trading days.

• Access through the Interactive Voice Response.

• You must speak to a Service Professional if you:– Wish to transact an Exercise and Hold.– Do not know your IVR trading PIN.– Do not use the Internet and you have special proceeds instructions (wire,

overnight delivery).– Do not have a touch tone phone.

Contact Center – Service Professionals

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• Call 1-800-367-4777 for Morgan Stanley’s Interactive Voice Response System to obtain a stock quote during market hours as well and enter either a market sell order or a limit sell order. – Automated response available 24 hours.– Service Professionals (SPs) are available from 8:00 a.m. – 8:00 p.m. ET, Monday

through Friday. – After market hours, you will receive last trading price.

• To speak with a Service Professional for other orders or questions.

• For questions on accessing the Internet or exercising online, call the Benefit Access help desk at 888-873-1194 or 801-617-7414, available from 8:00 a.m. – 8:00 p.m. ET, Monday through Friday.

Help Numbers

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© 2013 Morgan Stanley Smith Barney LLC. Member SIPC. CRC 677993 (06/13)

Tax laws are complex and subject to change. Morgan Stanley Smith Barney LLC (“Morgan Stanley”), and its affiliates and Financial Advisors do not provide tax or legal advice and are not “fiduciaries” (under ERISA, the Internal Revenue Code or otherwise) with respect to the services or activities described herein except as otherwise agreed to in writing by Morgan Stanley. This material was not intended or written to be used for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Individuals are urged to consult their tax or legal advisors before establishing a retirement plan or to understand the tax, ERISA and related consequences of any investments made under such plan.

Please note that the information contained herein is not investment advice or an offer to sell securities, but merely a general overview of how your stock options work. Morgan Stanley does not make any recommendations as to whether and when you should exercise your stock options or sell the shares you acquire upon exercise of your option. We suggest that you consult with your own tax or investment advisor about these matters, as well as the personal tax consequences of your stock option grant and the sale of your shares.

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