Got Company Stock Options? Here’s How They Work

by Alexis A. on 2010-07-187

How many of you have ever received stock option grants as part of your Total Compensation Package with your company? I’ve been getting documents (that reference my options) every Christmas from the company I work for and I would simply file away the large manila folder labeled Options into my desk drawer. It wasn’t until recently that I unearthed these documents and caught up with this information that I’d been missing all these years.

For those of you who get company stock options, pat yourself on the back. Your employer really appreciates the work you do and the effort you put forth in order to make them more successful. They appreciate this so much that they are actually giving you some ownership in the company by giving you an opportunity to buy shares of common stock in the company, usually at a reduced price. They’re also giving you the ability to reap the benefits of your company’s success.

company stock options, golden handcuffs
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The Basics of Company Stock Options

Let’s take a look at how this works:

Let’s take for example a hypothetical company I’ll call “Anderson Paperclips”. It has ten employees who work super hard to make the best paperclips on the planet. The owner of the company wants to reward his employees, but instead of giving them a bonus, which most of them will spend and forget about five minutes later, the owner decides to give them something more substantial. He decides to give them a stake in the company they are making great and the opportunity to directly influence just how much that monetary reward can be. But, instead of giving them shares of company stock, he gives his employees stock options.

Stock options are like contracts for the right to buy common stock in a company sometime in the future at a price that is set today. For instance, the employee stock options (another name for company stock options) I received last year allow me to purchase 500 shares of common stock with my company at $12.51 per share. The only catch is that I have to wait until the options mature before I can exercise my right to purchase. Hence the term often used to describe these things in the vernacular: golden handcuffs. It’s certainly one way to encourage people to stay employed at their place of work.

In my company’s case, the vesting or maturing period is 7 years. So, I have 7 years to do whatever I can to make my company as much money as possible before I exercise my options. The same (or something similar) would go for the employees of Anderson Paperclips.

When you exercise your options, you execute your right to buy the stock at the listed price on your contract. You can do this at any time after your award vests. I (and I imagine, most people) prefer to exercise these options and then sell them immediately, pocketing the difference between the exercise price and the current market price of the common stock, minus brokerage fees — hence the drive to make my company as profitable as possible. Others hold on to these options much like they would CDs or other savings products or keep them in their portfolios as a way to save for retirement.

The Benefits of Company Stock Options

This type of compensation is extremely good for the company that issues them. The reason is twofold. One, the money that they dish out to the employees is considered deferred compensation because the employee doesn’t get to utilize the award for several years after receiving it, thereby keeping more cash in the bank for the company. Also, the company benefits from having highly motivated employees who understand that their award’s value is purely based on the company’s performance, which is directly tied to their performance.

It’s kind of like getting free money from the company and who doesn’t like getting free money? If you are fortunate enough to work for a company that issues stock options, don’t slide those innocuous little manila envelopes into your desk drawer, scratch your head and whine about why a Christmas bonus would be better. Appreciate the fact that your employer believes in you and wants you to share in the success of the company you are helping to build. If you don’t get options, bring it up to senior management to see if this can be added to your compensation program.

A Word from SVB: Silicon Valley is known for handing out stock options, often in lieu of higher salaries. At one point (during the dot com era), it was fairly common — even expected — for employers to offer company equity as a form of compensation, with some startups offering employment based solely on “equity only” compensation. Definitely a sign of those times. In fact, at one point, I applied for a job with this kind of compensation package (yep, no real salary, just equity). Thankfully, I was rejected for the position as the startup in question imploded as part of the dot com bust. Learned my lesson here, and I’ll leave you with the advice to avoid “equity only” employment offers if you’re ever “lucky” enough to encounter them!

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{ 7 comments… read them below or add one }

Jesse W. July 18, 2010 at 9:36 am

Stock options are always very interesting as many CEOs and executives take them to avoid higher taxes. The issue comes when these executives backdate their stock options to a lower price to make some quick cash.

Hong July 18, 2010 at 11:39 pm

There is also the issue of alternative minimum tax when you exercise the options. Especially during the dot com era, you may find that you owe more taxes on the exercise price than they are worth when you actually get around to selling them. July 19, 2010 at 4:10 am

Like SVB said, in the era, stock options were as plentiful as sand in desert. If you did not get greedy and cashed out some before the bust, you may have made some decent money along the way.

Today stock options are reserved more for upper management and sometimes middle management. Less options make their way into the mainstream workforce. Its a sign of the times – an employers market rather than an employees market.

Silicon Valley Blogger July 19, 2010 at 7:40 am

Very good points! We only touched a bit on it here, but I agree that there are a lot of tax implications when dealing with this stuff. As I recall, it was one of those things we had to hand over totally to our Enrolled Agent to figure out. But I did read about how some people got into trouble with options when their taxes on them ended up greater than they were worth!

kt- lifedividend July 19, 2010 at 7:43 am

i know about these options but something that i would like to know how to do to perfection is how to short them. This is because the price of a stock option is much lower than the actual stock but to some extent it is just like the stock without the perks of an option. So in a sense you can short a company’s stock while putting up very little principal in a deal. Theoretically this seems very sweet. But the thing is that i don’t know how this is done. When i think of these options, i think of how they are misused by CEOs to their own benefit.

Consumermiser July 22, 2010 at 3:55 pm

@ Jessie W. I agree with your comment: Many CEOs and executives take stock options to avoid higher taxes. It’s also a pretty good way to force you to invest for the long term since you will hold the options for a time period.

@SVB, I agree with you, avoid “equity only” employment offers which are probably quite rare now in this “non-booming” economy, but were popular in the dot.bomb era, er, era. Make sure you get a salary which provides more certainty and security.

Habib July 29, 2010 at 6:40 am

I know about these options but something that I would like to know how to do to perfection is how to short them. This is because the price of a stock option is much lower than the actual stock but to some extent it is just like the stock without the perks of an option. So in a sense you can short a company’s stock while putting up very little principal in a deal.

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