When you think about your benefits package as an employee, you might think about health insurance, 401k, or paid time off. But some employers offer an additional benefit to their employees in the form of equity in the company.
Many companies — particularly startups or scale-ups — will offer stock options as part of your overall compensation package to recruit and retain top talent. The idea behind offering company equity is that you will essentially share in the company’s success, and will have the potential to sell your shares one day for a little (or a lot of) money.
For public companies (i.e., those trading on the stock exchange), equity is typically offered to employees in the form of a discount on their stock. Private companies are owned by a group of individuals, like the company’s founders and/or private investors, and the stock can’t be traded publicly.
For this article, we’ll focus primarily on private companies and what to expect when you’re granted stock options as an employee.
The offer letter and option grant
When you get an offer of employment with a new company, you will typically get a document to sign that lists your compensation package, including your salary and any bonuses you’ll be eligible for. If the company is offering you stock options as part of that package, those details will be listed in your offer letter as well.
While signing your offer letter means you’re accepting the job, there will be an additional step in the process if there are stock options included. You’ll need to sign the stock option agreement or “option grant” as well. It won’t cost you any money up front to accept the agreement, and signing it doesn’t mean you’re obligated to exercise your options in the future. It simply means you’ll have the opportunity to exercise if you choose.
Now to really throw you for a loop… stock options aren’t actually shares of stock. (Wait, what?!) The keyword here is “option” — the company is essentially giving you the option to buy a set number of shares in your company at a fixed price (i.e., the “strike price”). There are two types of employee stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). (The main difference between the two is how they’re taxed.) Your option grant will include details like:
- the type of stock
- number of shares
- the strike price
- your vesting schedule
It will also include an expiration date. (ISOs typically expire 10 years from the date they’re granted.)
If your new company offers you 1,000 shares as part of your compensation package, that doesn’t mean you have 1,000 shares on day one of employment. As I mentioned above, your option grant will include what’s called a vesting schedule. “Vesting” means you have to earn your stock options over time. Companies do this to encourage employees to stay on board for a more extended period. It helps with employee retention and makes employees feel more invested in the success of the company.
Most companies follow a traditional vesting schedule which includes what is called a “cliff.” A one-year cliff is the most typical, with 25% of your options vesting after one year with the company. (So, to get any shares at all, you must be with your company for at least a year.) After you reach your cliff, your remaining options (the other 75%) will continue to vest at regular intervals each month for the total length of your vesting schedule, which is typically 3 or 4 years.
So, for example: Upon hiring, your employer grants you 1,000 shares of stock with a vesting schedule of 3 years. On your first anniversary with the company, 250 shares (25%) will vest. Then, over the next two years, the rest of your shares (the other 750) will vest — about 31 shares each month for the next 24 months. Then, by your 3rd anniversary with the company, your options will be fully vested.
If you decide to leave the company before then, your shares will stop vesting, and you can only exercise the amount that has vested to date. You’ll have a window of time after leaving your company (usually at least three months) to exercise those vested shares, called a post-termination exercise (PTE) period. If you leave after three years, you’ll be able to exercise all 1,000 shares, should you so choose.
Strike price and exercising (no sweatband required)
Whether or not you want to exercise your vested shares will probably depend on how well the company is doing (or how well you expect it to do in the future) because you will have to purchase your vested shares. How much you will pay depends on your strike price.
The strike price is that fixed price listed on your option grant and is the price you’ll pay to exercise your vested shares. Companies set the strike price based on fair market value (FMV) on the day it’s granted. (So, depending on when you start at the company, your strike price may be different than someone else’s who started before or after you.) FMV is essentially what the price would be if the stock were publicly traded.
The difference between the FMV and your strike price is called “the spread.” So when the stock value is up, and the spread is positive, your options are considered “in-the-money.” If your spread is negative, your options are considered “underwater.” (So, for example, if your strike price is $1 and the FMV is $5, you’re essentially up $4/share.)
Another thing to consider when it comes to when/if to exercise is stock dilution. This happens when a company issues additional shares of stock, and in doing so, reduces how much of the company shareholders own. It typically occurs when the company raises money. Those new shares that have been issued would now cause the percentage of your ownership in the company to decrease.
So, when can I make money?
If you’re lucky enough to find yourself with stock options in a successful, growing company, there are a few main ways you may be able to cash in on your stock. Once you’ve exercised your vested options, you can choose to either hold onto them until there is an “exit event” or sell the stock to investors in a private transaction. The most common exit events are mergers, acquisitions, or an initial public offering (IPO).
Typically, in an acquisition and some mergers, your exercised shares are either paid out in cash or converted into common shares of the acquiring company. If your company goes onto an IPO, the private company is now public, and the company starts selling its stock on the market. There will be a “lock-up period” (of up to 180 days) in which employees aren’t allowed to sell their stock. After that period ends, you’re free to sell.
If you think your company has the potential for an exit event in the not-so-distant future, you’ll want to learn more about how your options might be affected. There are several complex factors to consider — including tax implications — when selling stock options. Talk to your human resources and/or legal team, and consider seeking out the advice of a qualified financial advisor to help you best understand your options.
*Disclaimer: This article is for general informational purposes only and not intended to provide specific advice or recommendations to any individual on any specific investment product or strategy. It is only intended to provide education about investments and the financial industry. Any ideas or strategies discussed should not be undertaken by any individual without consultation with a qualified financial professional.