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How Do Employee Stock Options Work?

Have you been offered employee stock options? If so, you may be wondering how they work. There are several factors you should consider to make the right decision about employee stock options.

At Gardner Employment Law, we are well-versed in the types of stock options and the financial benefits they provide. If you want expert advice about your stock options, give us a call.

What Are Employee Stock Options?

Employers offer stock options as a form of compensation for employees.  You are given the “option” or the opportunity to purchase stock in the company.  Employers connect the option with conditions that you must satisfy.

Companies frequently offer stock options to incentivize high performers to stay with the company. These are incentive stock options.  Or stock options may be granted as a reward for hard work.  A stock option grant sometimes is called an “award.”  Stock options may be offered as part of a compensation package when an employee is being hired.  As we discuss in Employee Stock Options, stock options have conditions, and most often stock options are accompanied by a contract or stock option agreement that you must sign.

How Are Stock Options Valued?

The option agreement or grant will contain specific terms that give the employee the ability to purchase stock in the company at a pre-set price. This price is called the “strike price,” but you may also hear it referred to as the grant price or the exercise price.  The price remains the same as when the stock option was offered, known as the “grant date.”  An employee benefits because most often the market value of the stock increases over time, while the employee can purchase the stock at the lower pre-set strike price.

Occasionally, when you prepare to exercise your options, the market price of the stock may be lower than the strike price.  If that happens, the stock is “under water,” as the phrase is used in the securities industry. Obviously, in that situation the options have no value.

When Can Employees Exercise Stock Options?

Employers most often grant options in installments or “tranches” with an increasing percentage of the options vesting over a period of time.  This is called a “vesting period.”  When a group of options vest, you then own the rights to whatever is stated in the agreement or the grant.  While the options remain unvested, you have no rights in them.

Many companies award employee options with a one-year cliff. This is a waiting period of at least one year before you can exercise your options.  That means that you must remain employed at least one year before exercising the options.  Stock options often have an expiration date after a certain amount of time, even after they are vested.  Employers give you a certain amount of time to decide if you want to exercise your option to purchase the stock. If you do not exercise your right to make the purchase before that date, the option expires.

The stock option agreement or the grant will determine the number of stock options granted to you, the vesting schedule regarding when the installments will vest, and any other critical dates.  If someone leaves the company before the options vest, the employee loses those options.

Stock Options Restrictions

Even if your options vest and you purchase shares of stock, the stock certificates may carry limitations such as “vested shares repurchaser rights” by the corporation, claw backs, non-competition restrictions on equity, or other negative restrictions.  Also, a departing employee usually is required to first offer his or her stock to the company or major shareholders, called a “right of first refusal.” With these limitations in mind, you must read the fine print to understand what value the stock options represent.

It will affect the value of your stock options and your shares of stock if the board of directors plans to sell the business or is open to selling sometime in the future. Companies in this posture want to avoid issues related to ownership of shares. Companies frequently insert restrictions on selling or transferring shares based on events related to a sale of the business. If there may be a change in control of the company in the future, you need to understand your rights and limitations if that event occurs.

Difference Between Stocks and Stock Options

Shares of company stock represent equity in the company, ownership rights. Stock options give you the opportunity to buy stocks in the future at a discounted price. The market price of the stock and the price of the stock option usually differ, with the option strike price offered at a lower rate.  Stock options can be lucrative.  As the company grows and becomes more profitable, causing the market price of the stock to rise, you have the right to purchase the stock at a lower price than the market price.

As Forbes writes, “The bottom line is that understanding the financial implications of your employee stock option packages is financially empowering.” If you manage your stock options judiciously, you can see long term capital gains that you wouldn’t obtain otherwise. Think about your financial goals. Whether it is creating rainy day savings, retirement funds, or providing money for your family, your goals should be central to your stock options strategy.

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Understanding equity and how it impacts your compensation package can move you closer to your financial goals. We can help you to implement your goals in understanding your stock options. If you want to leverage employee stock options to your advantage, give us a call.

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