Not to be confused with options traded by retail investors, employer stock options are a form of compensation used commonly by both start-up firms and well-established public corporations. Essentially, an employer stock option is a contract between employer and employee that grants the employee the right to purchase a stated number of company shares at a predetermined price (commonly referred to as the grant price).
Once options have been granted, the clock begins ticking on what is referred to as the vesting period, or period of time until the employee may sell (or exercise) these options. Vesting periods vary greatly from company to company and we will discuss this in more detail later. Once vested, options then have a stated expiration date – by which time the employee must choose to exercise the options. Employers also frequently require that you exercise your options within a shortened period of time should you leave the company.
When the employee does choose to exercise the options, they are buying the shares outright. Usually, employees sell these shares immediately at market price with the resulting income being equal to the difference between the market price of the shares and the grant price. For example, if Blake chooses to exercise and sell 100 shares of his XYZ company stock the income he receives is as follows:
XYZ Market Price: $50/share
Grant Price of Blake’s XYZ Option Contract: $25/share
$50 X 100 = $5,000 (Exercise Proceeds)
$25 X 100 = $2,500 (Cost to Blake)
$2,500 (Received in the Form of Short-Term Capital Gains)
The number of options that a company will grant its employees varies greatly. It depends on a multitude of factors – the seniority and skills of the employee, performance of the company, and performance of the individual employee, to name a few. Shares are also granted on a recurring basis (rather than simply at the outset of employment). This allows the firm to continually evaluate and reward these factors over time.
Why Would a Company Give Up a Portion of Their Ownership? Couldn’t They Simply Pay Cash Bonuses?
In theory, with a stake in the company, the employee will be more motivated to grow and improve the firm which, in turn, will lead the stock price to increase and consequently result in a significant profit on the stock option grant(s). Beyond the pure financial incentive, granting company stock also provides employees with the psychological benefit of ownership in their firm and an elevated sense of pride in their work.
Long-Term Employee Retention
Because stock options are granted with a “vesting period”, they require that the recipients continue to work for the company for a period of years before actually receiving any compensation from the grant. This characteristic makes options an excellent tool for retaining key employees that might otherwise accept attractive offers to leave for another firm. Should such an employee decide to leave, they’d be leaving “money on-the-table” in the form of forfeited, unvested options.
Cost-Effective Compensation Strategy
From the company’s perspective, stock options are an attractive form of compensation because they offer the future value of the company’s equity instead of cash up front. Options allow firms to save today’s dollars – deferring large portions of compensation for key employees to future years (when the options are exercised). As the old axiom goes, “a dollar today is worth more than a dollar tomorrow”. This is especially the case for newer, start-up companies that may not have the cashflow to pay competitive salaries and bonuses.
So, you know what stock options are and you know why companies choose to use them. But when should you exercise them? How do you go about exercising them and what if you are subject to “Blackout Periods”? Should you sell the shares you receive upon exercising your options or should you keep them if you feel good about the company’s prospects?
There are no perfect answers to these questions, but over the next several installments in this series we will explore how best to approach these questions and look at how your best strategy is one tailored to your personal goals and circumstances.