Stock Options — from The Holloway Guide to Equity Compensation
The following excerpt is from The Holloway Guide to Equity Compensation, a detailed reference with hundreds of resources on stock options, RSUs, job offers, taxes, and more. You can read more from this excerpt, or access the full guide text here.
THE FULL VERSION OF THIS GUIDE ANSWERS QUESTIONS LIKE:
What is the value in a low strike price?
How do stock options work?
What does it mean to exercise stock options?
What is the philosophy behind granting stock options?
Stock options are contracts that allow employees to buy a specified number of shares in the company they work for at a fixed price. Stock options are the most common way early-stage companies grant equity compensation.
A person who has received a stock option grant is not a shareholder until they exercise his or her option, which means purchasing some or all of their shares at the strike price. Prior to exercising, an option holder does not have voting rights.
The strike price (or exercise price) is the fixed price per share at which stock can be purchased, as set in the stock option agreement. The strike price is generally set lower (and often much lower) than the expected future value of the stock, which means selling the stock down the road could be profitable.
Stock options can be a confusing term. In investment, an option is a right (but not an obligation) to buy something at a certain price within a certain time frame. You’ll often see stock options discussed in the context of investment. What investors in financial markets call stock options are indeed options on stock, but they are not compensatory stock options awarded for services. In this Guide, and most likely in any conversation you have with an employer, anyone who says “stock options” will be referring to compensatory stock options.
Stock options are not the same as “stock.” Stock options are the right to buy stock at a certain price and under a set of conditions specified in an employee’s stock option agreement. Although everyone typically refers to “stock options” in the plural, when you receive a stock option grant, you are receiving an option to purchase a given number of shares. So technically, it’s incorrect to say someone “has 10,000 stock options.”
It’s best to understand the financial and tax implications before deciding when to exercise options. In order for the option to be tax-free to receive, the strike price must be the fair market value of the stock on the date the option is granted.
People familiar with stock trading (or those with economics degrees) will tell you about the Black-Scholes model, a general mathematical model for determining the value of options. While theoretically sound, this does not have as much practical application in the context of employee stock options.
