Key Terms For Stock Options #
Equity compensation, also called stock compensation, is a non-cash payment to employees through restricted shares and stock options. This perk allows employees to gain a stake in their companies, which means they own a small portion of the business and its profits. To make their offers more competitive, and to motivate their employees to do better work, startups that cannot pay out high salaries often include stock benefits in their hiring packages.
It’s critical to understand how to maximize stock benefits while mitigating risks when accepting a job offer. Getting the jargon down is the first step. The following terms help define how stock options work.
Grant Terms #
To understand stock options, we first need to familiarize ourselves with the terminology:
Strike Price (aka Exercise Price): How much you pay to purchase each share
The 409A value (aka fair market value): of the shares at the time you exercise the options.
- For private companies, FMV = 409A Valuation (which is an independent appraisal of how much the private company’s stock is worth)
- For public companies, FMV = company’s public stock price
Option term: is the length of time the employee can hold the option before it expires.
Typically, a company grants an employee a number of options to buy a stated number of shares at a defined grant price.
Vesting Terms #
Vesting: is the requirement that must be met in order to have the right to exercise the option-usually continuation of service for a specific period of time or the meeting of a performance goal.
These options vest:
- Over a period of time OR
- Once upon meeting specific goals
Some companies set time-based vesting schedules, but allow options to vest sooner if performance goals are met.
Exercise Terms #
Exercise: To exercise means the act of purchasing stock pursuant to a stock option.
Once vested, the employee can exercise the option at the grant price at any time over the option term up to the expiration date (usually up to 10 years from grant while employed at the company).
Early Exercise: Some companies allow you to purchase your unvested stock options. This is known as early exercising. Early exercising takes advantage of a low bargain element. If you exercise early enough, your bargain element will be close to zero and you will not owe any immediate taxes.
Exercise window: The exercise window, specified in your option agreement, tells you how many days to purchase any of your vested options if your employment ceases. Typically, companies either have 90-day or 10-year exercise windows but you should confirm in your contract
Bargain Element: Also known at the spread = (FMV of the stock at exercise) – (strike price).
Sale price: the price at which you later sell the shares.
Grant Example #
For instance, an employee might be granted the right to buy 1,000 shares at $10 per share. The options vest 25% per year over four years and have a term of 10 years. If the stock goes up, the employee will pay $10 per share to buy the stock. The difference between the $10 grant price and the exercise price is the spread. If the stock goes to $30 after seven years, and the employee exercises all options, the spread will be $20 per share.