Last Updated on May 19, 2023
Twenty years ago, the largest component of executive compensation was cash in the form of salaries and bonuses. Stock options were just a footnote. Now it’s the other way around. At an alarming rate, stock option grants dominate top executive compensation—and, in many cases, wealth.
So if you just got offered your dream job at a startup, the chance that your offer letter contained something about granting you stock options is really high.
You are first excited about this because “stock” means shares, which means you could be part of something great, right? Well, that may or may not be true.
This article will address what you should know about stock options.
What Are Stock Options?
Stock options are a type of employee benefit that gives employees the right to purchase company stock at a discounted price. This type of benefit is often offered to employees of startups and smaller companies as a way to attract and retain top talent.
Stock options give employees the ability to buy a certain number of shares of company stock at a predetermined price, known as the exercise price or strike price. The employee has the option to purchase the stock at any time before the expiration date of the stock option. If the stock price increases after the employee exercises the option and buys the stock, the employee can sell the stock for a profit. This can be a lucrative benefit for employees if the company is successful and the stock price increases significantly.
Read: What are the Top Funding Options for Startup Ventures?
Difference between stocks and stock options
Stocks and stock options are both securities that are traded on the stock market, but they are not the same thing.
Stocks represent an ownership stake in a company. When you buy stock, you are buying a small piece of the company. As an owner, you are entitled to a share of the company’s profits as well as the right to vote on certain company matters at shareholder meetings. The value of a stock can go up or down based on a variety of factors, including the company’s financial performance, market conditions, and investor sentiment.
Stock options, on the other hand, are a type of derivative security. A stock option gives the holder the right but not the obligation to buy or sell a certain number of shares of the underlying stock at a specific price (the strike price) on or before a specific date (the expiration date). There are two types of stock options: call options, which give the holder the right to buy the underlying stock, and put options, which give the holder the right to sell the underlying stock.
One major difference between stocks and stock options is the level of risk involved. Buying stocks carries more risk than buying stock options, as the value of a stock can fluctuate significantly over time, while the value of a stock option is largely dependent on the underlying stock’s price. Additionally, stock options have an expiration date, while stocks do not. This means that the holder of a stock option must use or lose the option before it expires, while the holder of a stock can hold onto it indefinitely.
Overall, stocks and stock options can both be useful tools for investors, but they serve different purposes and carry different risks and rewards.
What is vesting?
Vesting is a term used to describe the process of acquiring ownership of something, usually shares of stock or other securities. It is a way to ensure that employees who are given stock or other equity as part of their compensation package do not leave the company before they have had a chance to fully earn their equity.
There are two main types of vesting: cliff vesting and graded vesting. With cliff vesting, an employee must work for a certain number of years before they become fully vested and have the right to receive their equity. For example, an employee might be required to work for the company for three years before becoming fully vested.
Graded vesting, on the other hand, allows employees to gradually acquire ownership of their equity over time. For example, an employee might become 20% vested after one year, 40% vested after two years, and so on, until they are fully vested.
Vesting schedules can vary significantly depending on the company and the type of equity being offered. Some companies may offer more generous vesting schedules to help attract and retain top talent, while others may have more stringent vesting requirements.
Overall, vesting is an important concept in the world of compensation and equity, as it helps ensure that employees are motivated to stay with the company and contribute to its success over the long term.
What does it mean to exercise your options?
Exercising stock options means purchasing shares of the company’s stock at the price set by the option grant, also known as the exercise price. At a startup, employees may be granted stock options as part of their compensation package. Stock options give employees the right to purchase shares of the company’s stock at a later date, usually at a discounted price.
When an employee decides to exercise their stock options, they must pay the exercise price to purchase the shares. For example, if an employee has a stock option grant with an exercise price of $1 per share and they decide to exercise their options to purchase 100 shares, they would need to pay $100 (100 x $1) to the company to purchase the shares.
There are usually vesting periods for stock options, which means that the employee must meet certain requirements, such as remaining employed with the company for a certain number of years, before they are able to exercise their options. Vesting periods are intended to encourage employees to stay with the company for a longer period of time.
After an employee exercises their stock options, they become shareholders in the company. If the company’s stock price increases after the employee exercises his options, they can sell the shares for a profit. However, if the stock price decreases, the employee may end up losing money.
In summary, exercising stock options at a startup means paying the exercise price to purchase shares of the company’s stock, becoming a shareholder in the company, and potentially earning a profit if the stock price increases.
Why do startups use stock options?
Startups use stock options as a way to attract and retain top talent. They are a form of equity compensation that give employees the right to purchase a certain number of company shares at a fixed price (also known as the “grant price”) at a future date. This grant price is typically lower than the current market price of the company’s stock, so employees can potentially profit if they exercise their options and sell stocks at a higher price.
There are several benefits to using stock options as a form of compensation. First, they align the interests of employees with those of the company. By giving employees a stake in the company, startups can motivate them to work harder and contribute to its success. This can be especially important for early-stage startups that may not yet have the resources to offer high salaries or other forms of traditional compensation.
Second, stock options can be a flexible and cost-effective way for startups to compensate employees. Because they are granted at a fixed price, startups can adjust the number of options granted to employees based on their role and level of responsibility. This allows startups to reward top performers without incurring additional costs.
Finally, stock options can be a powerful tool for attracting and retaining top talent. Many employees are attracted to startups because of the potential for significant equity upside, and stock options can be a key part of that equation. By offering them, startups can differentiate themselves from more established companies and make their compensation packages more competitive.
How to turn stock options into cash
Stock options are a type of security that gives the holder the right but not the obligation to buy or sell a specified number of shares of a company’s stocks at a predetermined price within a certain period of time.
To turn stock options into cash, the holder must first decide whether to exercise their options. If they choose to do so, they must pay the predetermined price (also known as the exercise price or strike price) to buy the shares. The holder can then sell these shares on the open market through a brokerage account. The difference between the exercise price and the sale price is the profit or loss from the transaction.
If the holder does not wish to exercise their options, they can simply let them expire without taking any action. In this case, the options will have no value, and the holder will not be able to sell them or receive any profits.
It’s important to note that stock options are subject to vesting periods, which means that the holder may not have the right to exercise all of their options immediately. They may need to wait until certain conditions are met, such as reaching a certain number of years of service with the company or meeting certain performance goals.
Additionally, stock options may be subject to tax implications, so it’s important to consult with a financial advisor or tax professional before making any decisions about exercising options or selling shares.
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