Nancy Graham April 26, 2018 Personal Wealth What Are Stock Options (and How Do They Work)? From the prize inside the cereal box when you were a kid, to those “buy one, get one free” shopping deals, who doesn’t love getting a little extra something for nothing? So if you’ve been crushing it at work, and your employer offers you some stock options in return, that’s a prize worth smiling about too. BUT unlike a plastic toy or a free can of beans, company stock options can end up being worth anything from a hill of beans to a life-altering windfall. So, for these value-added puppies, it’s well worth asking a few critical “No Dumb Questions.” First: What is a stock option to begin with? That’s a choice question I’ll take on today. Congratulations to you! You’ve been pulling double-duty at work and your employer, a publicly traded company, is otherwise thriving thanks to your contributions. And to reward you and encourage you to stick around, your employer offers you company stock options. The problem is, they also offer you a pile of explanatory paperwork, and, O-M-G, it’s loaded with jargon and legal disclaimers. Not to worry. In today’s “No Dumb Questions,” let’s step through the basics on how stock options work. When you’re invited to participate in your employer’s stock option plan, you are given the right to buy (one) a stated number of company shares at (two) a stated price during (three) a stated time period. That stated price is known as your “strike” price. If you go ahead and actually buy some shares at the strike price, you’re exercising your option. To illustrate, let’s say on January first, your company – call it Acme Professionals, Inc. – offers you the option to buy 1,000 shares of Acme stock for $10 a share, with the option set to expire after 10 years. Acme may also attach strings to the deal in the form of vesting. Vesting prohibits you from immediately exercising your option, instead requiring you to wait until a certain period of time has passed. For example, after a year has passed, you may be vested, and allowed to exercise up to 50 per cent of your 1,000-share option. After two years have passed, you may be fully vested, with the right to exercise all 1,000 shares of your options anytime between then and when they expire. By the way, your employer may offer you multiple options over time. For example, Acme Professionals could offer you a second batch of options next year, this time at $12 per share, also good for the next 10 years under the same vesting arrangements. As you can imagine, it might not be long before you’ve got a lot of possibilities to ponder. Let’s start with the no-brainer choice. Let’s Say your $10 and $12 stock options are now fully vested. In the meantime, Acme’s “fair market value” has dropped to $8 per share on the public exchange. Should you exercise your option to pay more for the stock than it’s worth? Um … that’s a pretty clear “No way.” You’ve basically got zero incentive to take that offer. In fact, if the share prices were to remain depressed, you’d probably NEVER exercise your options, simply letting them lapse after the 10 years are up. They wouldn’t have cost you anything, but they wouldn’t have benefitted you either. Now let’s think more positively than that! What if the fair market value in our illustration ends up higher than your strike prices of $10 and $12 per share? Let’s say, once you’re vested, the stock is trading at $20 per share? That’s called “being in the money.” If you exercise your option to buy the stock at your strike prices, it’s instantly worth considerably more than what you’ve paid for it …and if you turn around and sell it, well, Score! As long as you stand to profit from exercising your options, the decisions start getting more complicated. First, when and how should you exercise your options? Also, once you do, how long should you hold the stock now that you’ve purchased it? For now, suffice it to say there are a number of factors to figure in, including cash flow, tax planning and incorporating your stock option benefits into your overall investment strategy. Can you guess what my next “No Dumb Question” will cover? If you’re thinking, “all of the above” … bingo! Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
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