How do stock options work?

Employee Stock Option write on sticky notes isolated on Wooden Table.
When an employee decides to exercise their stock options, it’s a milestone for them. They are now an owner in the business as a shareholder. An employee is using their money to buy equity, so what does all that mean whether you’re a startup founder or you’re an employee?
Below are the things to know about stock options and how they work.
The basics
Stock options give someone the right to purchase or sell shares of a stock at a particular price for a defined period of time. Stock options are traded on exchanges. A stock option has an original price, and then as you go forward, that price can move up or down.
The following are some of the terms to be aware of:
- Employee stock options: Specifically, as it applies to employees, stock options are an incentive. Employees can buy a defined number of shares at a specified price for a period of time.
- Call option: This term refers to giving the stock option owner the right to buy at a specific price during a window of time.
- Put option: A put option lets buyers have the option to sell their shares at a set price within a certain amount of time.
- Strike price: A strike price is when you’re able to exercise your options.
- Besting date: Shares vast over time usually. A vesting date is a date when you can use your grant. You can exercise your vested shares. The contract may also dictate that you can vest your shares all at once, which may be after a few years.
How do stock options work?
A stock option is part of an underlying stock, so its price is linked to the movement of that underlying stock. If the price goes up or down, the stock option will as well.
Stock options are considered alternative compensation companies offer, and startups frequently use them. Stock options are rolled into an overall compensation package for employees. An employee might start working for a startup for a lower salary than they would normally accept.
Then, they’re doing that in exchange for the potential of a bigger payout later on.
A company can grant stock options to employees and consultants, investors, and contractors.
Your offer doesn’t last forever if you’re an employee. You have an amount of time to exercise your options before they expire. If you leave the company, the employer could require you exercise your options within a period of time after that.
The options employers grant employees depend on the company. It can also depend on the role of the employee or their skillset. Any other stakeholders and investors have to approve an employee receiving stock options.
Granting and vesting
If you’re someone who gets a job at a new startup, and you receive stock options for, let’s say 30,000 shares of the company stock, you sign a contract. The contract includes the terms of your stock options, which can be included in your employment contract.
The contract will have the grant date. The grant date is when your options start to vest. Vesting means your stock options become available to you to actually buy or exercise. You don’t receive all of your options when you first start working for a company.
The vesting period is when the options gradually vest. If there’s a three-year vesting period, you have to wait three years before you can exercise all 30,000 of your options.
However, the options do usually vest over time during this period, so you can still access some of your options before that time.
There is a waiting period before any options vest. This is where you might hear a term—cliff. For example, if there’s a one-year waiting period or cliff, you’ll have to stay with the employer for at least a year to receive any options.
If you leave before that year is up, you won’t get any options.
If you stay and reach the cliff, you get part of your options, then the remaining vest, so you get equal amounts over the remainder of the vesting period.
Exercising stock options
After your options vest, you can exercise them, meaning you’re able to buy shares of company stock.
Your options don’t have any actual value until you exercise.
The price you pay when exercising your options was defined in the contract you signed. This is sometimes called the exercise price, strike price or grant price.
Regardless of company performance, this price stays the same.
When you exercise your options, you own the stock and you can sell it. You can also hold onto it with the hope it goes up.
You don’t necessarily have to use cash to buy all your options. One option to avoid putting up the money is called exercise-and-sell. You buy your options and sell them right away. You don’t use your own money to exercise. Instead, the brokerage making the sale will front you the funds, and then they use the money from the sale to cover the costs of purchasing the shares.
As you think about when you should exercise, your options vary.
You should probably wait until the company goes public if it’s going to. After the company has its initial public offering, you should only exercise your options when the stock price goes above your exercise price.
If the price goes up, you may want to hold onto your shares.
Beyond what we’ve talked about above, there are a lot of other things to know about stock options, including the tax implications.
For example, non-qualified stock options don’t get special tax treatment from the government, but incentive stock options do. If your shares are sold one year after the exercise date, they’re taxed as long-term capital gains.
These are things you need to talk to a financial professional about to understand the best options for you individually because it can get complex.