For example, if you are granted 5,000 stock options when the company's stock price is $1 per share, you have the option to pay $5K (5,000 shares * $1 per share) in the future to “exercise” and obtain the rights to these 5,000 shares regardless of what the future share price is
In this same example, if the future share price is $50 per share, the “fair market value” of these 5,000 shares is $250K (5,000 shares * $50 per share). That means if you can afford to pay $5K (plus taxes) to “exercise” those shares, you’ll own $250K worth of shares for an out-of-pocket cost of only $5k (plus taxes). Nice!
The tax implications of when you exercise and then sell your shares is where things get complicated and potentially quite stressful
What do I control with my stock options?
Once shares have “vested” you get to decide if you want to exercise and how many shares to exercise
Once you’ve exercised shares, if there’s a qualifying liquidation event (usually an IPO), you get to decide when you want to sell the shares
They key here is that this benefit is an option. This means you get to determine when you want to exercise, how many shares you want to exercise, and when you want to sell the exercised shares
Are stock options always going to produce net positive profits?
If your company's stock price rises, the discount between the stock price and the exercise price can make stock options very valuable
However, if the stock price decreases after the grant date, the exercise price will be higher than the market price of the stock, making it pointless to exercise the options—you could buy the same shares for less on the open market. These are called “underwater” stock options.
Thus, stock options incentivize you to work hard and improve your company’s market value. When your company does well, you reap the rewards through your stock options.
Are there different kinds of stock options?
ISOs are for employees only. They provide an opportunity for preferable tax treatment
With ISOs, if you hold the acquired shares for at least two years from the grant date and one year from the date of exercise, you incur favorable long-term capital gains tax (rather than ordinary income tax) on all appreciation over the exercise price
With NSOs, you will *always* pay the higher ordinary income tax on appreciation over the exercise price