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Terms and Definitions
Before taking advantage of your stock options or participating in an employee stock purchase plan, it's necessary to understand exactly what's being offered. Typically, an employer will provide an option agreement, explaining the stock option or employee stock purchase plan in which you're being invited to participate. This agreement will be filled with investment-related terminology you'll need to know in order to understand the terms of your option.
Before taking advantage of your stock options or participating in an employee stock purchase plan, it's necessary to understand exactly what's being offered. Typically, an employer will provide an option agreement, explaining the stock option or employee stock purchase plan in which you're being invited to participate. This agreement will be filled with investment-related terminology you'll need to know in order to understand the terms of your option. It will include details about the following.
Capital gains. Profits earned from selling an investment or stock. In the United States, you owe tax on the capital gains of an investment when you sell the shares and realize gains. You might also become tax-liable simply by purchasing shares or certain types of options, so make sure you know what you're getting when you exercise your options.
Dividend. A portion of profits a company or mutual fund pays to its shareholders.
Employee stock purchase plan. A type of employee benefit. Participants in this type of plan are often able to purchase stock at a discounted price (usually at a 15 percent discount from the current market value). Participants don't pay taxes on the investment until they sell their stock (for a profit, they hope).
Exercise. The process by which an employee purchases stock he or she has the option to purchase. Being offered an option does not require the employee to purchase the stock or exercise the option.
Exercise price. The price at which a holder of stock options is able to purchase the stock. Also called the strike price.
Expiration date. The date by which the owner of the option must decide whether to exercise the option and actually purchase the stock.
Going public. Also called an initial public offering (IPO). A company goes public when it makes the transition from being privately held (owned by individuals and private funds such as venture capital funds), to offering its first group of stocks for sale on a common market (via a stock exchange, such as the New York Stock Exchange). At this time, the value of the company - and its employees' options - often increases substantially, and the company's financial performance becomes accountable to the expectations of the entire market.
Grant price. The market price of a stock at the time the employee is granted an option. The employee may pay less than this amount if the exercise price is at a discount from the grant price.
Incentive stock option. This type of stock option meets certain requirements set up by the Internal Revenue Code. It's available only to employees of a company. With this type of option, income is reported only when the stock is sold, not when the option is received or exercised. If the stock is held long enough, the employee may report long-term capital gains instead of compensation income, which could offer a significant tax savings.
IPO. An initial public offering. This is the first sale of stock of a company in a publicly traded market, via a stock exchange (such as the New York Stock Exchange). See also going public.
Mature ISO stock. When purchasing incentive stock options (ISO), especially if the company is about to go public or has recently gone public, employees are commonly required to hold on to the stock (not sell their shares) for a predetermined period, often several years. When this holding period is over, the stock the employee owns is considered mature ISO stock and may be sold. The profit is then considered a capital gain as opposed to compensation income.
Nonqualified stock option. With this type of stock option, which has become very popular, the employee must report income upon exercising the stock. The gain - the difference between the sale price and the purchase price - is treated as income for tax purposes.
Option. The right, but not the obligation, to purchase something at a specific price at a specific time. In compensation terms, a stock option.
Option agreement. A document (or series of documents) that outlines the terms of and rules pertaining to an employee's stock options.
Prospectus. A document describing the financial details associated with an investment opportunity. Companies that offer stock are required to issue a prospectus. It contains background information about the company - its products and services, its financial situation, and its financial forecasts. A prospectus is designed to help an investor make educated decisions about an investment opportunity.
Shareholder. Someone who owns stock (shares) in a company. These are the people to whom the company is ultimately accountable for its financial performance. Note that option holders are not in the same league as bona fide shareholders.
Spread. The difference between the current market value of a stock and the strike price.
Stock purchase plan. Offers made to employees allowing them to purchase a stated number of shares of stock.
Strike price. The price at which a holder of stock options is able to purchase the stock. Also called the exercise price.
Vesting. The period over which an employee has the ability to realize rights, such as stock options or employer matching contributions to retirement savings plans. For example, a retirement savings plan might have a five-year vesting schedule, where after each year of employment the employee has the right to keep an additional 20 percent of employer contributions to the account. Or, an employee might be vested in 25 percent of his or her stock options after each six months of employment. Vesting schedules vary from company to company. A stock is considered "vested" when the employee may leave the job, yet maintain ownership of the stock with no consequences. Employees of some companies may need to meet certain requirements after exercising options, such as remaining with the employer for a predetermined period, in order to keep the stock.
- Jason Rich, Salary.com contributor
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