Andrea is a practicing attorney and MBA with 15 years experience in health care administration, litigation and business law.
What Are Stock Options?
You've worked hard in school. Now as a result of your perseverance and good grades, you've landed several job interviews with prestigious companies. When reviewing their offers, you notice that some companies boast a generous compensation package, including eligibility for stock options. Should you be excited? First, you need to know what a stock option is and how much it is worth.
A stock option is an agreement between an employer and employee that allows an employee to buy a fixed number of shares of company stock at a specific price, usually within a set period of time. The employee stock option agreement spells out all the details, including the rules that apply to the option plan.
Another important term to know is grant price (also called the strike price or exercise price). This is the price at which the employee will be able to purchase the stock. Typically, employees must wait a specified period before being allowed to exercise the option. At this point, the stock option is vested, which means the wait period has passed. After the vesting period, employees may elect to exercise the option. At that point, the employer is obligated to sell the employee company stock at the grant price. The employee can then sell the stock and collect the proceeds or hold onto it in the hope the price goes up further. If the employee chooses not to exercise the option during the time allowed, it will lapse. Unexercised stock options have no value after they lapse.
Why Stock Options?
We now know about stock options, but why do employers offer them? Well, stock option plans can be an attractive way for companies to share ownership with employees, reward them for good performance, and increase motivation. Stock options represent an ownership interest in the company and so they are often used as a form of incentive pay. Pay incentives are amounts in addition to base compensation designed to reward employees for good performance. Pay incentive programs include bonuses and profit sharing, which are also known as variable pay.
As of 2014, 8.5 million employees in the U.S. hold stock options, according to the independent research organization, NORC, at the University of Chicago. In the past, stock options were mainly given only to top executives. Now, large, publicly traded companies, such as Starbucks, Southwest Airlines, and Cisco, give stock options to most or all of their employees. More than ever before, it's important for employees to understand stock options, including the basics of how to value them in order to determine how much they are really getting.
Value of Stock Options
Publicly held companies generally offer stock options to employees at the current trading price on the day the options are granted. If the market price of the stock goes up in the future, employees can exercise their stock options and collect the difference between the grant price and the current market price.
Now, let's look at how to calculate the value of an unexercised stock option. It's pretty simple. Start with the current market price of the stock, then subtract the grant price. Lastly, multiply that difference by the number of shares for which the option can be exercised. The number you get is called the intrinsic value, or the amount of profit that could be made if you were to exercise the stock option. Let's look at an example to better understand this.
Two years ago, Joan was granted a 10-year stock option to purchase 1000 shares of her employer's stock at a price of $25 per share (which is the grant price). The market value of the stock today is $50 per share. Now, we plug these numbers into our formula, which gives us our new equation: V = (MP - GP) * S, or V = (50 - 25) x 1000.
When we solve, we get our intrinsic value, $25,000.
Risks and Benefits
As we've demonstrated, under the right circumstances, stock options can produce a big payout for employees. Stock option plans are very attractive when the company's stock price is rising, but the reverse is true when the stock price drops. If the company's stock price falls below the grant price or stays stable, the value of the stock options is essentially zero. What may look good on paper actually produces little or no actual gain in terms of real dollars for the employee.
Another risk is that employees may accumulate too many options in their employer's stock at the expense of having a diversified investment portfolio. Many employees come to rely on stock options for long-term savings goals, such as retirement and college tuition for their children, but in doing so become overly reliant on the fate of the company. In such cases, these employees' financial well-being may be dictated by forces largely outside of their control.
There are benefits to stock options for employees aside from the potential for a big payout. With stock options, the employee doesn't always need to commit any of his or her own funds to exercise the option. In a cashless exercise, a shareholder can exercise options and simultaneously sell enough of the stock to cover the purchase price.
Generally, a stock option is not counted as income to the employee for tax purposes until the option is exercised or the stock is sold (depending on the type of option). From an employer's perspective, stock options can be attractive because they can serve to increase employee commitment to the organization since their compensation is more directly tied to company performance.
Stock options are a popular form of incentive pay representing an ownership interest in the company. A stock option is an obligation between the employer and employee, allowing the employee to purchase company stock at a particular price. The employer will provide an employee stock option agreement, which tells the employee the grant price, the vesting date, and the number of shares available for purchase. The employee can determine the intrinsic value, or the amount of profit that could be made by exercising the stock option after the vesting date has passed. If the stock price is above the grant price, the employee can exercise the option, sell the shares, and collect a payout. If the stock price has fallen below the grant price, the option has no intrinsic value.
Stock options are so prevalent now, that it's important to understand what they are and how they operate. Employees should be especially aware of the risks and benefits of stock options when evaluating their total compensation package and making investment choices. Given the complexity of taxation and valuation issues, employees would be well advised to consult an accountant or financial advisor before making any financial decisions involving employee stock options.
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