Canadian Finance Blog

Posted: 19 Apr 2011 02:00 AM PDT

A friend of mine was recently offered some company stock options and wanted to know more about how stock options worked. Stock options are becoming more commonly used as incentives for all company employees, not just the corporate executives. Company stock options often have a complicated contract that explains the various scenarios on how to exercise these options. My friend wasn't sure if he was being given the stock as a bonus, or if he had to purchase the stock in order to reap the benefits.

Let’s start with an explanation of what stock options are:

Employee stock options give you the right to buy a specific number of shares of your company's stock during a time and at a price that is specified by your employer. Companies make stock options available for several reasons:

They want to attract and retain great employees.
They want their employees to feel like owners of the business (think WestJet).
They want to hire skilled workers by offering compensation that goes beyond a salary. This is especially true in start-up companies that want to retain as much cash as possible.

Benefits of Stock Options

The price that the company sets on the stock (called the strike price) is discounted and is usually the market price of the stock at the time the employee is given the options. Since those options cannot be exercised for some time, the hope is that the price of the shares will go up so that selling them later at a higher market price will yield a profit. Unless the company goes out of business or doesn’t perform well, offering stock options is a good way to motivate employees to accept jobs and stay on. These stock options promise potential cash or stock in addition to salary.

To help you understand how this might work, let's look at an example. Say your company gives or grants its employees options to buy 100 shares of stock at $10 per share. The employees can exercise the options starting July 1^st, 2012. On July 1^st, 2012 the market value of the stock is $15. Here are the choices for the employee:

Convert all of the options to stock, buy it at $10 per share, and hold it with the idea of selling it in the future for a capital gain.
Convert the options to stock, buy it at $10 per share, then turn around and sell all the stock after a waiting period specified in the options’ contract. If an employee sells those 100 shares, they would gain $5 per share, or $500 in profit.
Sell some of the stock after the waiting period and keep some to sell later. Again, the employee has to buy the stock at $10 per share first.

Vesting Period

Whatever choice an employee makes, the options must be converted to stock, which brings us to another aspect of stock options: the vesting period. In the example above, employees could exercise their options and buy all 100 shares at once if they wanted to. Usually a company will spread out the vesting period over three, five or even 10 years, and let employees buy shares according to a schedule. Here’s how that might work:

You get options on 100 shares of stock in your company.
The vesting period for your options is spread out over four years, with one-fourth vested the first year, one-fourth vested the second, one-fourth vested the third, and one-fourth vested the fourth year.
This means you can buy 25 shares at the strike price the first year, then 25 shares each year after until you’re fully vested in the fourth year.

Remember that each year you can buy 25 shares of stock at a discount, then keep it or sell it at the current market value of the stock. And each year hopefully the stock price continues to rise.

What Else Is There To Know?

It's important to know that stock options always have an expiration date. You can exercise your stock options starting on a certain date and ending on a certain date. If you don’t exercise the options within that period, you lose them. And if you are leaving a company, you can only exercise your vested options; you will lose any future vesting.

A privately held company establishes the strike price on each share of its stock by assigning a price that is related to the internal value of the share. This is established by the company’s board of directors through a vote.

Stock options do have some risk, and they are not always better than cash compensation if the company is not successful. But they are becoming increasingly more popular in certain industries as an incentive to attract and retain their employees.

How Stock Options Work? originally appeared on Canadian Finance Blog on April 19, 2011.