What Are Non-Qualified Stock Options?
Non-qualified stock options are the most popular type of employee stock options used by companies in compensation packages for valued employees. Firms find it to be in their interest to use stock options as a means of retaining and motivating personnel. There was a time when non-qualified employee stock options were largely reserved for top executives. Today, millions of mid-level managers and professionals also have the opportunity to benefit from them.
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Identification
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When a company grants a non-qualified stock option, the employee receives the right to buy a stated number of shares of the company's stock at a fixed strike price. The option is good for a limited time (usually several years) and the employee can exercise the option anytime until it expires, although companies usually impose a waiting period. The term "non-qualified" serves to distinguish regular employee stock options from a special form often called incentive options. Profits from non-qualified stock options are taxed as regular income, but incentive stock option profits may qualify for lower capital gains tax rates.
Function
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The idea behind non-qualified stock options is simple. The strike price is normally set equal to or above the market price at the time the option is granted. If the stock goes up in value, you can exercise the option and buy the shares at the strike price, then sell them at the market price. For example, if the strike price is $10/share and the stock eventually appreciates to $25/share, you can buy the shares at $10/share and sell them at $25/share, making $15 per share. If you bought options for 10,000 shares, that works out to $150,000.
Cashless Exercise
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When an employee exercises a non-qualified stock option, he has to buy the shares before selling them on the market and may not have the ready cash the transaction requires. However, it's common practice to use a strategy employed by options traders called a cashless exercise to avoid this problem. The employee takes the options to a broker who "lends" the money to pay the strike price, then sells the shares and reimburses herself. The broker tacks on a fee for services and deposits the employee's profits in his brokerage account.
Reload
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Suppose an employee has non-qualified stock options and the company's stock has risen substantially, but the expiration date for the options is still some time away. This poses a dilemma. The employee can wait, hoping the stock will go up even more, but in so doing takes the chance the stock will decline. Many non-qualified stock options avoid this by including a reload feature. The employee can exercise the option. The company issues a new option with the same expiration date but with the current market price as the strike price. That way the employee can secure the profits to date and still benefit from future increases in the stock's value.
Considerations
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Companies generally prefer non-qualified stock options because they get a tax break that's not available with incentive options. They also have the choice of revaluing non-qualified stock options if the share price falls. That is, the company can then reset the strike price to a lower figure so employees can benefit if the stock recovers (revaluing is not allowed under SEC rules for incentive options). Non-qualified stock options have some distinct advantages for employees as well. With an incentive option, the employee has to hold the stock for a year after exercise to qualify for capital gains tax rates. This requires the employee to have the cash to commit for the one-year holding period and to accept the risk that the stock may decline during that time.
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