What Are Stock Options: An Investor’s Guide

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Today’s most prolific companies are often made up of the greatest employees. In fact, it’s not the least bit hyperbolic to suggest great employees make even greater businesses. There’s no doubt about it: The greater the concentration of highly esteemed employees, the more likely a company is to excel. Consequently, many of today’s businesses will do whatever it takes to bring in the best talent, not the least of which includes offering employee stock options.

Not unlike other popular incentives, stock options have the ability to attract world-class talent to a company. Few incentives are more attractive to prospective employees than options, which begs the question: What are stock options?

Let’s take an in-depth look at what employee stock options are, and how they help everyone involved.

What Are Stock Options?

Not to be confused with options (calls and puts), employee stock options are essentially incentives used by public companies to reciprocate their appreciation for the hard work of their employees. Similar to that of a raise or a bonus, or perhaps even as motivation to bring on new talent, companies will reward their employees with the ability to buy stock options (shares of their public company).

In their simplest form, employee stock options are rights bestowed upon employees by their employers to buy shares of the company they work for at a specified time and price. Instead of buying shares of the business on the open market, employees are granted access to shares through the company—usually at discounted prices.

Employee stock options are used to compensate employees and attract new talent. That said, they may complement salaries, or even incentivize employees to work harder and meet specific goals. Lately, stock options have been popularized by startups which don’t necessarily have a lot of money. Instead of offering to pay employees outrageous salaries, startups void of cash may offer to compensate workers with stock options. While some stock options may prove risky for some employees, the upside is tremendous and may result in a significant payday down the road.


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Stock options

How Do Stock Options Work?

When an employee is invited to participate in a stock option plan, they are given the right to buy a stated number of shares at a predetermined price within a specified amount of time. In the event an employee is granted access to participate in a stock option plan, the employer will set four parameters:

  1. The Number Of Options Available: The employer will predetermine the number of stocks the employee will be able to buy as part of the plan.

  2. The Strike Price: Employees will be told the price at which they may be allowed to purchase each share.

  3. The Option Duration: The company will set a limit on the amount of time the employee can exercise their options.

  4. The Vesting Period: While not every employee stock option requires a vesting period, some plans will require employees to wait a certain amount of time until they can exercise their options.

Once it has been determined an employee may participate in the company’s stock option plan, the employer will grant them the ability to buy a certain number of shares for a set price over a predetermined period of time. Doing so will grant employees access to shares at a locked-in price for the foreseeable future.

There is no definitive number of options a company must offer an employee, nor a set price. The number of shares an employee may receive and the price they are asked to pay are determined by several factors. The employee’s status at the company and their seniority may dictate their compensation, as well as any milestones they reach while vesting. In other words, employee stock options vary from company to company, and even from employee to employee.

Stock Option Example

Let’s say, for example, your company has recognized the great job you have done for them since being hired. In an attempt to show their appreciation, the owner allows you to participate in the company’s stock option plan. Upon delivering the good news to you, the company agrees to let you buy 1,000 shares for $10 apiece. At the time of announcing the good news, the company will also tell you the ability to exercise the option will expire in 10 years.

Instead of being able to buy shares at the strike price immediately, however, you must be fully vested, meaning you will have to wait a predetermined amount of time until you can exercise your options.

Once the vesting period is up, you now have the option to buy up to 1,000 shares of the company for $10 each within a 10 year period. Provided the share prices on Wall Street are greater than $10, the employee stock option looks like a great deal (and an even better employee incentive). If shares jump to $15 during the time you are allowed to exercise options, you may still acquire them for $10 (the agreed-upon strike price)—$5 less than their market value. That way, every share you buy comes with instant equity. Therein lies the greatest benefit of exercising employee stock options: locking in a low strike price with a growing company can result in a windfall of equity.

It is worth noting, however, that shares of the company may also drop over the 10 year period you are allowed to exercise your option. In the event shares drop below the strike price, you won’t want to exercise your option to buy shares. Say, for example, the shares drop to $5 apiece while your stock option window is open. If you were to exercise your option, you would still pay the strike price ($10) for something that only costs $5. Needless to say, it wouldn’t be worth exercising your $10 strike price.

When all is said and done, employee stock options are only as good as the company offering them. If you work for a company with unlimited growth, exercising an employee option to buy shares at a low price for a decade can provide a life-changing sum of money. However, companies that routinely watch their stock price drop may offer little to no benefit to the employee.

How To Invest In Employee Stock Options

To invest in stock options, employees must first be granted access to the program by the employer. Once it has been determined the employee will partake in the stock option program, the employer will set the strike price, the number of available shares, the vesting period, and investing duration.

More often than not, employees will need to wait until they are fully vested in the company. Once vested, however, the employee may buy as many shares at the strike price as they want (without exceeding the number of shares the employer made available). Remember, the shares must be purchased; the employer won’t do it for the employee. Until the option is exercised, there’s no real value in the program.

Once the employee exercises their option, they own the stock, and they are free to sell it whenever they like. That said, stock options may be held with the intention of them increasing in value, or they may be sold immediately. The investment strategy will depend on the employee’s goal and the health of the company. It is important to note that stock options are not exempt from the usual fees that accompany investing in stocks: commissions, fees, and taxes still apply. All of this may be done through the brokerage hired by the employer.

What Are Restricted Stock Options?

To understand what restricted stock options are, investors must first familiarize themselves with the vesting process. Otherwise known as a vesting schedule or vesting period, the vesting process serves as a trial period for the employer.

Instead of the employer granting access to shares of the company at a strike price immediately, they will typically wait until the employee is fully vested in the company. Doing so prevents the incentives from fully being taken advantage of, and provides a period of time in which the employee proves that they deserve the reward. More importantly, the vesting period gives the employee an incentive to perform well and stay with the company.

Vesting periods follow a predetermined schedule which is established by the employer at the time the option is awarded to the employee. That way, the employee knows exactly how long they need to keep performing at an acceptable level before they can exercise their options. When all is said and done, vesting is a waiting period the employee must endure before they can take advantage of the incentive.

While vesting, however, the shares are restricted. Employees know exactly what they will have access to eventually, but until the vesting period is over, the assets are restricted. Otherwise known as restricted stock units (RSUs), restricted stock options are shares of a company the employee doesn’t have access to immediately. The shares the employee will eventually gain access to are restricted during the vesting process—hence their restricted namesake. Once the employee is deemed vested, the shares become available and are no longer restricted.

Restricted Stock Options Vs. Stock Options

The “restricted stock options vs. stock options” debate has proponents on each side. Employers are granted a safety net which prevents employees from taking advantage of the system, and hard-working employees know exactly what’s expected of them.

On the one hand, restricted stock options allow employers to incentives their employees with a great reward if they do what is asked of them. In their simplest form, restricted stock options are the carrot on the end of the stick; employees can see the reward they are working for, but it’s just out of reach. Employees, on the other hand, are made privy to their potential reward and are allowed to determine for themselves whether or not the end justifies the means.

Summary

What are stock options, if not for one of the best ways to incentivize employees? Few other benefits, for that matter, offer the same type of upside as stock options at a promising company. There is very little downside to exercising stock options, but the upside can be significant, and can often result in a very lucrative payday if the company increases in value.

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