Being offered stock options by your new employer sounds exciting, like you’re getting exclusive access that could pay off down the road.
And you might be.
When you’re offered options, “in some ways you’re being permitted to share in the growth of the company,” says certified financial planner Herb White, founder and president of Life Certain Wealth Strategies in Colorado.
“It aligns your interest with that of the company, and when that company is publicly traded, the offer aligns your interest with the shareholders,” he explains. “Generally I would say the offer of options means the company is interested in trying to retain you as an employee, and is offering an incentive to help you profit as the company grows.”
Also, he adds, “it’s a potentially very lucrative scenario for an employee.”
But what do your options mean?
In many cases, a “stock option” is exactly what it sounds like: the option to buy the company stock.
We’ll use the term “stock option” here to refer to non-qualified Employee Stock Options, or ESOs, which are the most common type of equity grant an employee might receive. Some companies might offer Restricted Stock Units (RSUs), instead, but among private companies like startups, where equity is a common form of compensation, ESOs are more widespread.
As you can imagine, stock options can get pretty complicated. For our purposes, though, here’s a high-level overview of what happens when your employer offers you a standard package including options:
If you’re offered, say 1,000 shares by your employer, a startup that’s still privately owned, that means you have the option to buy that many shares at today’s price, called the “strike price” or “exercise price” … but you can’t buy them today. Options usually come with what’s called a “vesting schedule,” which enables you to take ownership of more of your options the longer you remain at the company.
A typical vesting schedule, explains EquityZen CEO Atish Davda, is four years with a one-year “cliff.” That cliff means you can’t start claiming your options until you’ve been with the company for a year. Then, you might get access to 25%, working up until you get 100% of your options after four years. Now you have the option to buy all of the shares originally offered, but you still don’t own those shares.
To own the shares, you have to “exercise” your options — that is, write the company a check to buy those options at the agreed-upon price from your initial offer. Let’s say your offer of 1,000 shares had a strike price of $US1. To buy the shares, you have to cut a $US1,000 check (or a $US500 check to buy half your shares, if you don’t have $US1,000 on hand). Perhaps the market value of these shares is now $US5 each, but you get to purchase them at $US1.
That money still isn’t in your pocket.
“When you exercise your options and buy the stock for $US1, you get a share certificate that says ‘Congrats, you have a share certificate that’s worth, in today’s price, $US5 per share,'” explains Davda. “In reality you don’t get cash, because the company is still private. You’re holding a piece of the company you hope will get acquired or issue a dividend, or have an IPO. Until then all you have is the sheet of paper.”
Ideally, your company will be acquired or issue a dividend or have an initial public offering, and the stock will be worth considerably more than you paid for it so you can sell it at a profit. There is the possibility that your stock will be worth less than you paid for it, also known as being “underwater.” That is not the preferred outcome.
This is a very basic overview of what it usually means to be granted stock options as part of your compensation package. Bear in mind, however, that employee equity in a company generally comes with a lot of fine print: It takes different forms, has different tax treatments, and may affect your portfolio in different ways.
For that reason, Davda recommends that employees get professional advice from a financial planner or accountant if options are a part of their compensation.
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