How do stock options work?

Benefits of Stock Options

The price the company sets on the stock (called the grant or strike price) is discounted and is usually the market price of the stock at the time the employee is given the options. Since those options cannot be exercised for some time, the hope is that the price of the shares will go up so that selling them later at a higher market price will yield a profit. You can see, then, that unless the company goes out of business or doesn't perform well, offering stock options is a good way to motivate workers to accept jobs and stay on. Those stock options promise potential cash or stock in addition to salary.

Let's look at a real world example to help you understand how this might work. Say Company X gives or grants its employees options to buy 100 shares of stock at $5 a share. The employees can exercise the options starting Aug. 1, 2001. On Aug. 1, 2001, the stock is at $10. Here are the choices for the employee:

  • The first thing an employee can do is convert the options to stock, buy it at $5 a share, then turn around and sell all the stock after a waiting period specified in the options' contract. If an employee sells those 100 shares, that's a gain of $5 a share, or $500 in profit.
  • Another thing an employee can do is sell some of the stock after the waiting period and keep some to sell later. Again, the employee has to buy the stock at $5 a share first.
  • The last choice is to change all the options to stock, buy it at the discounted price and keep it with the idea of selling it later, maybe when each share is worth $15. (Of course, there's no way to tell if that will ever happen.)

Whatever choice an employee makes, though, the options have to be converted to stock, which brings us to another aspect of stock options: the vesting period. In the example with Company X, employees could exercise their options and buy all 100 shares at once if they wanted to. Usually, though, a company will spread out the vesting period, maybe over three or five or 10 years, and let employees buy so many shares according to a schedule. Here's how that might work:

  • You get options on 100 shares of stock in your company.
  • The vesting schedule for your options is spread out over four years, with one-fourth vested the first year, one-fourth vested the second, one-fourth vested the third, and one-fourth vested the fourth year.
  • This means you can buy 25 shares at the grant or strike price the first year, then 25 shares each year after until you're fully vested in the fourth year.

­Remember that each year you can buy 25 shares of stock at a discount, then keep it or sell it at the current market value (current stock price). And each year you're going to hope the stock price continues to rise.

Another thing to know about options is that they always have an expiration date: You can exercise your options starting on a certain date and ending on a cert­ain date. If you don't exercise the options within that period, you lose them. And if you are leaving a company, you can only exercise your vested options; you will lose any future vesting.

One question you might have is: How does a privately held company establish a market and grant (strike) price on each share of its stock? This might be especially interesting to know if you are or might be working for a small, privately held company that offers stock options. What the company does is to fix a price that is related to the internal value of the share, and this is established by the company's board of directors through a vote.

Overall, you can see that stock options do have risk, and they are not always better than cash compensation if the company is not successful, but they are becoming a built-in feature in many industries.

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