What Are Incentive Stock Options (ISOs)?
Incentive Stock Options, or ISOs, are a type of stock option that companies offer to their employees as a form of non-cash compensation. ISOs can be a valuable tool for building long-term wealth and aligning employee interests with company success. Essentially, they give you, the employee, the option to buy company stock in the future at a price that’s determined today. This price is known as the “strike price” or “exercise price.” The idea is that if the company’s stock price goes up, you can buy the stock at the lower strike price, potentially earning a profit on the shares. But if the price stays the same or goes down, you don’t have to do anything so there is no cost to you.
Key ISO Terms
Strike Price: The predetermined price at which you can buy the stock. Think of it as a guaranteed price tag for your future stock purchase. This is usually, but not always, the current value of the stock at the time the options are granted.
Exercise: An option gives you the right to buy (or sometimes sell) an underlying asset, in this case company stock. Using that option, in other words choosing to buy the stock at the strike price, is known as “exercising the option”.
Expiration: An option gives you the right to choose when to buy your company stock at a predetermined price, but it doesn’t last forever. With ISOs you usually have 10 years to exercise your options before they “expire” and are worthless. If you leave the company, you may only have a short period of time to exercise your options before they expire. Make sure you check your plan documents to know for sure.
Vesting: This is the process through which you earn the right to exercise your options. You usually don’t get all your options at once; they become available to you (or “vest”) over time, encouraging you to stay with the company. You can exercise vested options, you can’t exercise options that haven’t vested yet.
Cliff: Often, there’s a “cliff” at the beginning of the vesting period. If your vesting schedule includes a one-year cliff, for example, you won’t vest any options until you’ve been with the company for a full year.
How ISOs Work
Imagine your company grants you 1,000 ISOs with a strike price of $10 each, a four-year vesting period, and a one-year cliff. Here’s what that means for you:
Year 1 “The Cliff”
You must remain employed for one year after the grant date to earn any options. If you leave before the year is up, you get none.
Post Cliff: After the first year, let’s say 25% of your options vest, meaning you can now buy 250 of the total 1000 shares at $10 each, no matter what the current stock price is.
Years 2-4: The remaining options typically vest monthly or annually. If they vest monthly, you might earn the right to purchase around 21 shares each month until you reach the total 1,000 shares vested at the end of year four. It’s important to understand that vesting is different than exercising. As the options vest they become yours to do what you want with, it doesn’t mean you have to do anything.