Stock Options

All of us dream of working for a company that is handing out employee stock options these days. Why? Because we’ve all heard of the thousands of young employees working for the dot com venture companies becoming instant millionaires (commonly called “dot cot millionaires”) when they cash in on their employee stock options. While most of us have certainly heard of employee stocks options, perhaps not all of us are quite sure exactly what they are. Let’s briefly explain “What are employee stock options?”, and illustrate this spin on an investment vehicle.

Simply put, an employee stock option is an option contract issued by a company to its employees as a form of compensation. Please see “what are stock options” for a definition of that term. In other words, a company usually issues options for their employees as a mechanism of recruiting talent without immediately expending any capital.

Perhaps the best way to explain this is by a brief illustration:

Let’s say that Alpha company wants to recruit a new CEO to run it’s hot internet division that has just recently begun operations. They are willing to pay a salary of $200,000 for the first year. They find Bob that just happens to be the perfect candidate for the job. The only problem is that Bob is not willing to work for less than $300,000 per year. How can these parties come to terms and strike a deal that is beneficial for each?

How about an employee stock option! Alpha’s stock is currently trading for $10 per share. Bob knows that this young company is set to explode over the coming years. Alpha and Bob can enter into an agreement (an employee stock option, “ESO”) whereby Alpha agrees to grant Bob an option to purchase 10,000 shares of Alpha, executable after 1 year of service, for a price of $10 per share.

If Bob and the company do a great job in the first year, Bob knows that the stock price could easily triple to $30 per share. If it does, Bob could purchase the 10,000 shares of Alpha and sale them after one year for a profit of $200,000.

Utilizing employee stock options Bob and Alpha were able to meet both of their needs. Alpha hired a great employee for less than he should be paid (at least as far as initial cash outlay goes). Bob grabbed an opportunity to earn more than he should be paid, if the stock increases as he expects it to. It’s a win-win for both parties!

Hopefully this simple definition and explanation of employee stock options explains the concept well enough. If you have any questions, thoughts, additions, or comments, please feel free to fire away. We sincerely thank  you for visiting and wish you the very best!

We are commonly asked, “What are stock options?” Being in the financial “game” for so long, we forget that the majority of folks out there really don’t understand investment terms, much less fairly complicated terms and instruments such as stock options. With that in mind, here is a brief explanation and description of what stock options are. If you would like to add to this simplified definition, please feel free to do so.

The simplest stock option definition is simply that it gives the holder the right to buy or sell stock at a specified price by a specific date. In other words, the person that purchases a stock option may choose to purchase or sell the underlying instrument (the “stock” itself) in the future, for an amount that is determined when the option is granted by the seller.

Let’s put this working definition into a practical explanation. Pretend that Mary owns 100 shares of Google stock. Let’s say that Google’s stock is currently valued at $500 a share. Now Ben approaches approaches Mary and inquires about entering into an options contract for her Google stock. They both agree that Ben will have 10 days to purchase all of Mary’s shares in Google for $500 each. For entering into this contract, Ben immediately pays Mary $1 per share ($100).

If 10 days go by and Ben does not execute upon the agreement, this stock option contract will expire and Mary gets to keep her Google shares, along with the $100 profit.

If they are in the US, Ben can execute the options contract at any time before it expires by simply purchasing the shares or selling them. If they are in Europe, Ben can only execute upon the agreement on the 10th day.

Why would Ben want to purchase or sell the Google stocks? Because Google’s stock prices went up! Let’s say that on the 8th day Google’s shares were trading for $600. Ben could immediately act upon the stock options agreement and sell all of the shares on the market, which would yield him a return of $100 per share (minus any fees).

Why would Ben not want to purchase or sell the shares of Google? Because the price has fallen! Let’s say that the value of Google stock has fallen to $400 on the open market. If Ben acted upon the stock option he would be a fool because he would have to pay Mary $500 a share, while he could purchase the same stocks on the open market for only $400! In this example, Ben would just let the option expire and count the $100 cost as a sunken expense.

Hopefully this answers “What are stock options?” for you. We realize that it is simplistic, but we all need to start from somewhere. We gladly welcome any thoughts, additions, questions, or comments that you may have. Thank you very much for visiting us today.