Stock Options For Dummies®


by Alan Simon




About the Author

Alan Simon is a computer consultant, author of 26 books (including Data Warehousing For Dummies), and farmer. He has held a number of executive positions in technology consulting firms, and has been a computer professional since the late 1970’s. His extensive experiences with his own stock options — sometimes painful experiences — have provided him with an objective, no-hype perspective of stock options that he imparts in this book.

Alan lives on a farm in Northeastern Pennsylvania.


Author’s Acknowledgments

I’d like to thank the editors with whom I worked on this project including Jonathan Malysiak, Keith Peterson, and Suzanne Thomas for their valuable assistance with this book. I would also like to thank Matt Wagner of Waterside Productions. Jay Klapper, Keren Hamel, and Scott Temares provided valuable assistance with stock option anecdotes and experiences. I would also like to thank Bruce Brumberg of; Wade Williams of; Thomas Grady of; and Dale Krieger of


Publisher’s Acknowledgments

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Some of the people who helped bring this book to market include the following:Acquisitions, Editorial, and Media Development

Project Editor: Keith Peterson

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Cover Image: © Scott Barow/Imagestate 2005


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Publishing and Editorial for Consumer Dummies

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Publishing for Technology Dummies

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Composition Services

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The publisher would like to give special thanks to Patrick J. McGovern, without whom this book would not have been possible.




Why I Wrote This Book: The Lessons of 1999 and 2000

Who Needs to Read This Book?

How to Use This Book

How This Book Is Organized

Icons Used in This Book

Part I : The Fundmentals of Stock Options

Chapter 1: Stock Options: What You Need to Know Right Off the Bat

Understanding Stock Option Basics

Exercising Your Stock Option(s)

Understanding the Right Nature of Your Stock Options

Comparing Stock Options to Actual Shares of Stock

Granting Stock Options: Why Do Companies Do It?

Comparing the Two Main Types of Stock Options

Chapter 2: Taking Your Chances: Getting Rich or Going Broke

Making Lots of Money: The Upside to Stock Options

When Good Options Go Bad

Stock Options as Golden Handcuffs

Reading the Oxygen Meter on Your Underwater Stock Options

Chapter 3: Knowing What Kind of Stock Option Situation Is Best for You

Assessing Your Attitude: Entrepreneur, Investor, or Working Stiff?

Considering Your Personal Situation

The Two Different Types of Employment Situations

Putting It All Together

Determining the Best Situation for You

Chapter 4: The Big Guys and The Big Picture

Recognizing the Big Guys?

Understanding Other Big Guy Investment Vehicles

Knowing How Much of Your Company the Big Guys Own

The “Friends and Family” Stock Program

Part II : Details, Details: What You Must Know about Your Stock Options

Chapter 5: Deciphering the Legal Language of Stock Option Agreements

Knowing What an Employee Stock Option Agreement Is

Figuring Out What Kind of Stock Option(s) You Have: ISO or NQSO

Trudging Through the Details of Your Stock Option Agreements

Knowing When Your Option Is Exercisable

Chapter 6: Exercising Your Stock Options

The Four Reasons to Exercise Stock Options

Procrastinators, Beware! Getting All of Your Paperwork in Order

The Mechanics of Exercising Stock Options

Exercising Pre-IPO Stock Options

How Much Money Do You Need to Come Up With?

Chapter 7: Differentiating Pre-IPO and Post-IPO Stock Options

What Is an IPO?

Receiving Pre-IPO Stock Options

Receiving Options When Your Company Is Already Publicly Traded

Chapter 8: No Trading Allowed! Lockups and Blackout Periods

Understanding Post-IPO Lockups

Getting Through Blackout Periods

Chapter 9: Finding Stock Option Information Online

The National Center for Employee Ownership (NCEO)

EDGAR? Who’s That?

Part III : Money!

Chapter 10: Determining What Your Stock Options Are Really Worth

Valuing Stock Options

The Value of Your Stock Options at Grant Time

Determining What Your Stock Options Are Worth Now

What Your Stock Options Should Be Worth

Determining What Your Stock Options Might Be Worth in the Future

Chapter 11: Stock Options and Your Overall Portfolio

Counting the Baskets

Understanding the Principles of Personal Financial Planning

Considering Your Equity (Stock) Holdings

Investing in Your Employer

You’re Wealthy! But Is Your Wealth Real or Only on Paper?

Sector Exposure

Part IV : Pay Up! Taxes and Stock Options

Chapter 12: Understanding the Basics of Taxes and Stock Options

Deciding How Much You Want to Worry about a Tax Strategy for Your Stock Options

Warnings and Possible Surprises Waiting for You

Key Tax Concepts

State Tax Considerations and Michael Jordan?

International Tax Considerations

Chapter 13: Nonqualified Stock Options and Taxes

What Is a Nonqualified Stock Option (NQSO)?

Understanding the Basics: NQSOs and Taxes

Complicating the Situation

Understanding the Section 83(b) Election

Tax Withholding and Exercising NQSOs

NQSOs and Your Tax Forms

Timing Troubles: When Should You Exercise NQSOs?

Another Key Decision: Which Option(s) Should You Exercise?

Chapter 14: Incentive Stock Options and Taxes

What Is an Incentive Stock Option (ISO)?

Talking Taxes and ISOs: The Basics

Disqualifying Disposition of an ISO

Nondisqualifying Disposition of an ISO

The Stock Option Titanic Scenario

Beware the Wash Sale Rules!

Can Section 83(b) Help with the AMT Situation?

Part V : Changes and Special Circumstances

Chapter 15: The Alternative Minimum Tax and Stock Options

Understanding the AMT

Calculating AMT

Getting Some of Your AMT Payments Back

State Taxes and AMT Considerations

Chapter 16: Acquiring or Being Acquired: Dealing with Corporate Change

Understanding Why Companies Sell Out

Dissecting the Deal

Private and Public Companies: The Mix-and-Match Combinations

What Happens to Your Options After a Change of Control?

Understanding the Tax Implications of a Change of Control

A Final Word: It’s a Whole New Ballgame After a Change of Control

Chapter 17: Trying to Predict What Will Happen to Your Stock Options

Looking at What’s Going on Inside Your Company

What’s Going on Outside Your Company?

Chapter 18: Leaving Your Job: What Happens to Your Stock Options?

Does the Reason You’re Leaving Matter?

Tick, Tock, Tick, Tock . . . The Clock Is Running

Should You Sign a Termination Agreement?

Exercising Stock Options After You’ve Already Left

Read Your Stock Option Agreements Now!

What Happens to Pre-IPO Options If You Leave?

What About Underwater Stock Options?

Read Your Overall Employment Agreement

Beware the Dreaded Clawback Provision!

How Does Your Soon-to-be-Former Stock Option Package Affect Your New Job’s Compensation?

Special Job Change Circumstances and What Happens to Your Stock Options

Get the Lawyers! Lost Stock Options and Lawsuits

Part VI : The Part of Tens

Chapter 19: Special Stock Option Circumstances

Understanding the Three R’s: Repricing, Reissue, and Reload Options

Using Stock Options as Currency

Chapter 20: Ten Signs That Your Stock Options Will Be Worth a Lot!

A Steadily Growing Company

A Stable and Highly Qualified Management Team

A Very Active Board of Directors

Relatively Low Turnover Among Employees

Market-leading Products or Services

Returning Customers

Good Internal Systems and Infrastructure

Employee Empowerment

Thorough New-Employee Training Programs

Chapter 21: Ten Signs That Your Stock Options Will Probably Be Worthless!

The Serial-Entrepreneur Management Team

A Disinterested Friends and Investors– Dominated Board of Directors

A Revolving Door of Managers

Last One Out, Please Turn Out the Lights!

Rose-Colored Glasses Syndrome

High Levels of Customer Dissatisfaction

Poor Internal Systems and Infrastructure

Open Talk Among Employees About Leaving

Inconsistent Internal Communications from Management

A Sense of Panic

Chapter 22: Ten Things to Look for in Your Stock Option Agreement

What Kind of Options Are You Receiving?

Are the Dates Consistent and Logical?

Are There Inconsistencies in Details?

Is There a Clawback Provision?

Is There a Provision for a Change of Control?

Are the Expiration and Cancellation Details Clear?

Are There References to the Company’s Stock Option Plan?

What Is the Effect of a Stock Split?

What Can You Do and Not Do with Pre-IPO Options?

Are There Differences Among Stock Option Agreement Documents?


Even though an estimated 12 million U.S. employees have stock options as a key component of their respective compensation packages, many of those people understand only the most basic aspects of their stock options.

This lack of stock option knowledge, however, is understandable when you realize how most companies handle the granting of stock options to their employees. When a job offer is extended, a representative from the HR (Human Resources) department will usually follow up the salary offer with a bland, imprecise statement, something along the lines of “oh, yeah, you also get 5,000 stock options.”

But no mention of the vesting schedule for those shares, no mention of how the strike price for those 5,000 shares will be set, and usually no mention of what kind of stock option grant you will receive — an incentive stock option (ISO) grant or a nonqualified stock option (NQSO) grant, each with different tax consequences. (If this book is your first exposure to the world of stock options, don’t worry about the terminology in the preceding paragraph: I cover those terms along with other stock option basics in Chapter 1.)

Why I Wrote This Book: The Lessons of 1999 and 2000

I wrote Stock Options For Dummies for several reasons:

bullet To demystify the complex terminology, rules, and tax consequences of stock options

bullet To provide readers with a realistic picture of what to expect from their respective stock options

bullet To help readers get beyond the “you’ll certainly get rich!” pitch from less-than-candid prospective employers, and to evaluate stock options as part of an overall compensation picture

You can look at the years 1999 and 2000 to see stock options in a realistic light. For most of the 1990s, having a stock option package was like having a license to print money — very often, lots of money. The stock option phenomenon reached its crest in 1999 as technology stocks and Internet-related stocks in particular zoomed beyond any realistic measures of the underlying values of the companies themselves. The “first day pop” (the day a company went public) became sort of a contest by 1999: Could the company’s stock price go up 300 percent the first trading day? 400 percent? Even more?

But the boom was fun while it lasted, and many employees of those companies became wealthy — perhaps even extremely wealthy — primarily on the soaring value of their stock options. The primary concern of many option holders during the late 1990s was how to minimize taxes on the spectacular gains on those options. But the spectacular gains were never in question: They would happen, and quickly!

Alas, when technology stocks — and, again, Internet stocks in particular — crashed during 2000, many of those stock option millionaires or billionaires watched as their wealth shrank or even vanished. In some cases, the plummeting in the value of any given individual’s stock options couldn’t be prevented, given the rules of stock options with regard to when an option holder is — and isn’t — to cash in on paper gains. In other cases, though, the “now you have it, now you don’t” magic trick that caused hundreds of billions of dollars in stock option paper wealth to vanish could have been prevented, at least in part.

How? If a stock option holder had followed some of the basic principles of investing and managing a portfolio, then that person may have realized that the company’s stock had gone way too high, way too fast. Therefore, that person would have “taken some of the money off the table” by cashing in some of those shares of stock and redeploying the proceeds into other investments. Alas, for so many option holders (just like many technology stock investors in general), greed and unrealistic expectations became the order of the day, and the price was eventually and painfully paid when stock prices went into a tailspin.

But did the stock market of 2000 signal the end of stock options as a key component of employees’ compensation packages? Reading some of the press stories near the end of the year, you might think so. “Employees leave behind worthless stock options, seek higher salaries” was the prevalent theme of so many news stories during the fall of 2000, so you might be tempted to think of stock options as little more than a passing fad whose best days were in the past.

I disagree. The stock option genie is out of the bottle, and even those whose dreams of stock option-fueled wealth and early retirement didn’t pan out have had a taste of aspiring to more than just a salary from their respective jobs. I believe that stock options are here to stay, but many people will (hopefully) be much more realistic and much smarter about their options packages in the days ahead.

And that’s where Stock Options For Dummies comes in: to provide that “big picture view” of stock options that takes into consideration not only the basics such as vesting schedules and tax laws, but also the following:

bullet How to read your stock option agreement paperwork and look for traps

bullet How to figure out if the company making you the job offer with the stock options is a “real” company with solid prospects or just a fly-by-night, get-rich-quick scheme for venture capitalists and its founders — but not for you and your coworkers

bullet Understanding the consequences to your stock options of leaving your job, having the company sold, or some other significant change

bullet Where to find up-to-date information, group discussion, and assistance on the Internet about critical stock options issues

Who Needs to Read This Book?

Stock Options For Dummies is intended for anyone who has a current stock option package, whether it’s doing well or not; anyone who is considering a job with a stock option package and needs to watch out for traps, make sure he’s being treated fairly, understand what he’s getting into; and finally, anyone who wants a no-hype, realistic discussion about stock options: the good, the bad, and the ugly.

How to Use This Book

Stock Options For Dummies is written in easily understood language from cover to cover, with liberal use of examples. Some of the topics covered are very basic — the stock options basics covered in Chapter 1, for example — while other material, such as the chapters on stock option taxation, is more advanced.

Some readers for whom stock options is a brand new topic (that is, readers who have never had a job with stock options) would be best served by first reading the book cover to cover, and then using the book as a reference for specific topics that come up in the future (for example, finding out an employer is being acquired by another company, and wanting to figure out what will happen to existing stock options).

Other readers with a bit more exposure may want to selectively read certain chapters, and either skip or skim others. I recommend at least skimming every chapter, even if you currently have stock options or have held options in the past and understand the basics pretty well. Most chapters contain not only the basic information about that chapter’s subject but also anecdotes and “gotchas” that you may not have come across — yet!

Many of the chapters have a number of cross-references to other chapters — more than you would find in a typical . . . For Dummies book. The reason is that so many stock options topics are interrelated, and I wanted to be as thorough as possible within any given chapter to point you to another chapter (or two or three chapters) where you will find related information about a specific example or anecdote.

How This Book Is Organized

Stock Options For Dummies is organized into six parts. The chapters within each part cover specific topics in detail, as described in the following sections.

Part I: The Fundamentals of Stock Options

The chapters in Part I cover the fundamentals and are particularly appropriate for readers who are newcomers to the world of stock options. (But I recommend even experienced option holders skim the chapters to pick up a tidbit or two with which they aren’t familiar or haven’t yet come across.)

Chapter 1 covers the stock option basics that you must understand to make informed decisions about accepting a job and an accompanying stock options packages. Vesting, strike prices, how you might make money on your options: It’s all in there. Chapter 2 takes an honest, no-hype, no-holds-barred look at “the good, the bad, and the ugly” sides of stock options. Stock options aren’t a license to print money, nor are they some type of evil incarnate tool. Stock options are simply a financial instrument that can greatly benefit those who own them, but by no means are those benefits guaranteed.

Building on the basics in the first two chapters, Chapter 3 helps you develop your philosophy about stock options. Should you look at stock options as an entrepreneur might, or are stock options simply a bonus that supplements your salary? You need to match your philosophy to the right stock option situation: the type of company, the type of stock option package you receive, and the amount of risk you’re willing to accept.

Finally, Chapter 4 takes a look at the big guys and their stock options, as well as other equity-based instruments they usually have at their disposal. Maybe you’re a big guy yourself, or hope to be one day. Make sure that you’re being treated fairly, on par with the other big guys at your company, by being as informed as possible.

Part II: Details, Details: What You Must Know About Your Stock Options

The Part II chapters add nuts and bolts onto the basics and philosophical aspects of Part I. Chapter 5 helps you understand the language in your stock option agreement — a legally binding agreement — and where to watch out for hidden traps. Chapter 6 steps you through the process of exercising your stock options, and what happens if you immediately sell the shares you acquire from the exercise versus what happens if you hold on to those shares.

Chapter 7 discusses the differences between stock options in pre-IPO companies and those companies that have already gone public, and what happens to your stock options along the way. Chapter 8 discusses two key restrictions — blackout periods and lockup periods — that govern when you can and can’t exercise options and sell shares. Finally, Chapter 9 take you into the Internet and a guided tour of online resources where you can find the latest and greatest about stock options, applicable tax laws, and related material.

Part III: Money!

The two chapters in Part III help you gain a realistic sense of the value of your stock options on their own and in the context of your overall portfolio. Chapter 10 discusses stock option valuation, including different approaches of varying complexity you can use, while Chapter 11 helps you figure out how to balance your stock options and other investments you have in your employer (such as actual shares of stock you hold) with your other investments and your personal and family needs.

Part IV: Pay Up! Taxes and Stock Options

Taxes and stock options can be very complicated, and some of the most serious mistakes people make with their stock options include not understanding the tax consequences of their actions such as exercising and selling shares. Chapter 12 presents the basics of taxes and stock options, providing the foundation for the subsequent chapters in Part IV. Chapter 13 covers taxes on nonqualified stock options (NQSOs), while Chapter 14 discusses taxes on incentive stock options (ISOs). Finally, Chapter 15 takes a brief look at the alternative minimum tax (AMT).

Part V: Changes and Special Circumstances

As time marches on, you may very well find your job and your stock options affected by various circumstances. Chapter 16 discusses what happens to your stock options if your company is acquired. Chapter 17 helps you pick up hints and clues about what might happen to your stock options in the future — will they soar in value, or plummet into nothingness? Chapter 18 discusses what happens to your options when you leave your job — different situations will likely apply whether you are laid off, resign, retire, become disabled, or die while still an employee. Finally, Chapter 19 discusses various types of special circumstances that may change key aspects of your stock options — for example, changes to the strike price, if the options are repriced.

Part VI: The Part of Tens

Each Part of Tens chapter presents ten elements about a key stock option topic. Chapters 20 and 21 give you lists of items that may foretell whether your stock options will be worth a lot or may become worthless, respectively. Chapter 22 ties in with the material in Chapter 5, and warns you about ten key things to look for in your stock option agreements before you sign them.

Icons Used in This Book

As with all . . . For Dummies books, the text is annotated with icons to call your attention to various points I make (or try to make!) about stock options.


When you see the Tip icon, the accompanying material is some action you should consider taking.


The Warning icon is exactly that: a warning of some dire consqeuence that might occur should you make the wrong move with your stock options.


When you see the Technical Stuff icon, the accompanying material falls into that category of “thanks, but that’s more than I really needed to know.” You can certainly get the gist of any chapter’s contents by skipping over the Technical Stuff material, but if you want to get under the hood for that chapter’s topic, a few moments spent with the Technical Stuff material will help you thoroughly understand that topic.


The Remember icon calls your attention to a point that was made earlier in the chapter or in an earlier chapter, or highlights a key point or two that you should remember.

Part I

The Fundmentals of Stock Options

In this part . . .

This part explains the basics of stock options: how they work, how you might make a lot of money, and — sorry to say — how your stock options might turn out to be little more than a “wouldn’t it have been nice” fantasy. You’ll see how to match different types of employment situations and stock option packages to your own circumstances and tolerance for risk to help maximize your chances for stock option profits. You’ll also get a look at the types of stock option packages the “big guys” in your company — like the CEO and the Board of Directors — have.