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Stock Options Part 2: How do stock options work?

Posted by Brian Waller | Sep 22, 2021 | 0 Comments

As explained in our prior blog post, stock options ARE income for the purposes of child support. Exactly how this works can be complicated, though. Stock options are a popular incentive that enables small startups to compete with much larger companies to hire talent. It is a win-win, employees get an opportunity to participate in the company's success, and the company gets the benefit of an employee that otherwise may have taken their talents elsewhere (maybe even South Beach). But there is a common misconception that just because someone was granted stock options that they automatically become wealthy. Most often, stock options will only have value a year or more in the future, and only if the company's stock price is higher than the ‘strike price', or the stated cost of each share to the employee. 

What is a stock option grant?

A grant or award of stock options refers to the issuance of a set of stock options by a business to an employee. At this point, it will be helpful to see an example of a stock option grant, and you can click on the image to the right to see what a stock option grant letter looks like.

Stock Option Grant Example
Example stock option grant letter

Basically, a grant of stock options to an employee will state the number of options granted, the strike price or cost of each option to the employee,  and the vesting schedule for those options. For example, an employee may be granted 1,000 options at a price of $1.00 that vest over 4 years. 

How much are stock options worth?

This is the million-dollar question, but unfortunately, based on the stock option grant alone, there is no way to tell. We are missing one key piece of information: the current stock price of the company's stock.

If the employer is a privately-held company, there is most likely no value at all. This is the case for early-stage technology or other startup companies. They hope that their stock will be sold on the public stock market at some point through an Initial Public Offering (IPO), but until then, the stock options are essentially worthless until that happens.

For a public company, meaning a company that is 'publicly held' or owned by its shareholders, its stock can be bought and sold on a public market like the New York Stock Exchange or NASDAQ. If the company's stock price is higher than the stock option grant price, then those options are worth money. If the stock price is lower than the grant price, the stock options are "underwater" or basically worthless.

When you hear about people making millions from stock options, it is usually the result of the employee being granted options at a low price, then the company's stock price increasing drastically. So the 1,000 stock options in our example above with a grant price of $1.00 would be worth $50,000 if the company's stock price rises to $50 per share. This is the outcome that everyone hopes for. 

What is Vesting?

There is one other thing potentially standing in the way of converting those stock options into cash or income: vesting. Vesting is basically a time-based schedule for certain rights to be earned. In the context of stock options, this is the timing of when those stock options actually become exercisable by the employee. Simply put, stock options usually vest a little bit at a time over multiple years. The most common vesting schedule in my experience is a 4-year vesting schedule. The way these usually work is that 25% of the options granted will vest on the one-year anniversary of the grant date, then 25% each year over the next three years. So if an employee is granted 1,000 stock options, none of those would be exercisable until one year has passed. After the first year, 250 could be exercised, and the remaining options may vest monthly or quarterly over the next three years. 

Why aren't they just granted to employees all at once? Primarily, employee retention. If an employee was granted 1,000 options that vested immediately, they would have no incentive to stick around as an employee. By spreading out the options over several years through vesting, the employee gradually has the opportunity to exercise more of their options and they have a great reason to remain as a faithful employee because they stand to benefit from the continued growth of the company and increase in its stock price. 

About the Author

Brian Waller

Founder and Principal Attorney

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