What are stock options in a startup?
Employee stock options are the most common among startup companies. The options give you the opportunity to purchase shares of your company’s stock at a specified price, typically referred to as the “strike” price. Your right to purchase – or “exercise” – stock options is subject to a vesting schedule, which defines when you can exercise the options.
Let’s take an example. Say you’re granted 300 options with a strike price of $10 each that vest equally over a three-year period. At the end of the first year, you would have the right to exercise 100 shares of stock for $10 per share. If, at that time, the company’s share price had risen to $15 per share, you have the opportunity to purchase the stock for $5 below the market price, which, if you exercise and sell concurrently, represents a $500 pre-tax profit.
At the end of the second year, 100 more shares will vest. Now, in our example, let’s say the company’s stock price has declined to $8 per share. In this scenario, you would not exercise your options, as you’d be paying $10 for something you could purchase for $8 in the open market. You may hear this referred to as options being “out of the money” or “under water.” The good news is that the loss is on paper, as you have not invested actual cash. You retain the right to exercise the shares and can keep an eye on the company’s stock price. Later, you may choose to take action if the market price goes higher than the strike price – or when it is back “in the money.”
At the end of the third year, the final 100 shares would vest, and you’d have the right to exercise those shares. Your decision to do so would depend on a number of factors, including, but not limited to, the stock’s market price. Once you’ve exercised vested options, you can either sell the shares right away or hold onto them as part of your stock portfolio.