• Investing & Markets

While-You-Wait Investing: Stock Options

October 18, 2018 | Shannon Lynch, CFP®

Learn all about stock options in the time it takes to steep a cup of tea:

Stock options are probably the most well-known form of equity compensation.

A stock option is the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise” or “strike price,” for a fixed period of time, usually following a predetermined waiting period, called the “vesting period.” Most vesting periods span follow three to five years, with a certain percentage of options vesting (which means you’ve “earned” your shares, though you still need to exercise (i.e., purchase them).

When it comes to options, one of their biggest advantages is leverage. With more options per grant relative to other forms of equity compensation, there is significant upside potential But despite the upside, these don’t come without risk.

Stock options are commonly used to attract prospective employees and to retain current employees.

The incentive of stock options to a prospective employee is the possibility of owning stock of the company at a discounted rate compared to buying the stock on the open market.

The retention of employees who have been granted stock options occurs through a technique called vesting. Vesting helps employers encourage employees to stay through the vesting period to obtain the shares granted to them. Your options don’t belong to you until you have met the requirements of the vesting schedule.

For example, assume you have been granted 10,000 shares with a four-year vesting schedule at 2,500 shares at the end of each year. This means you have to stay for at least one full year in order to exercise the first 2,500 shares and must stay to the end of the fourth year to be able to exercise all 10,000 shares. In order to receive your full grant, you will likely have to stay with your company the full vesting period.

There are many other considerations to think about when it comes to stock options at part of your employee equity compensation package, such as when and how to exercise. To learn more about stock options and other forms of equity compensation, read our free “Guide to Employee Equity Compensation”.

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