What it means
The fixed price is called the exercise price or strike price, and it is normally set at the market value of a share on the day the option is granted. If the share price later climbs, the holder can buy at the old price and either keep or sell the shares at the new one.
Options almost always come with a vesting schedule, which is the timetable that decides when the right actually becomes usable. A typical arrangement vests over four years with a one-year cliff, meaning nothing vests until the first anniversary and the rest accrues monthly after that.
Companies use options because they conserve cash and align incentives. A start-up that cannot match a large employer's salary can offer a share of the upside instead, and the employee only profits if the business becomes more valuable.
The accounting is often misunderstood by non-finance managers. Options are not free: the company recognises a share-based payment expense in the income statement over the vesting period, and exercised options dilute existing shareholders by increasing the share count.
Tax treatment varies enormously by country and by scheme type, and the timing of the tax charge, at exercise or at sale, is usually the biggest practical issue for employees. Options can also expire worthless if the share price sits below the strike, a situation described as being underwater.
In practice
Real-world examples.
Example
A software start-up offers a senior engineer a salary $25,000 below the market rate plus 40,000 options at a $2 strike. The engineer accepts because a future sale of the business could make the options worth far more than the forgone cash.
Example
A listed retailer grants options to its store managers with a three-year vesting period. Two managers who resign after eighteen months forfeit the unvested portion entirely, which is exactly the retention effect the scheme was designed to create.
Example
A biotechnology company sees its share price halve after a failed trial, leaving most staff options underwater. The board approves a fresh grant at the lower price rather than repricing the old options, to avoid the shareholder backlash repricing usually attracts.
Think of it
“Employee stock option is the right to buy company stock at a set price-potential upside.
Formula
Calculation
Pre-tax gain on exercise and sale = (Market price per share - Exercise price per share) x Number of options exercised.
An employee is granted 5,000 options with an exercise price of $12 per share, vesting over four years. Four years later the shares trade at $30 and the employee exercises all 5,000 options.
Buying the shares costs 5,000 x $12 = $60,000. Selling them immediately at $30 raises 5,000 x $30 = $150,000. The pre-tax gain is $150,000 - $60,000 = $90,000, which is the same as 5,000 x ($30 - $12) = $90,000. Had the shares instead traded at $9, the options would be underwater and worth nothing, because nobody pays $12 for a share they can buy on the open market for $9.Case study
Seen in the real world.
Verity Analytics is a fictional company invented for this illustrative example. It granted every one of its 60 employees options at a $12 strike during a funding round, and told staff simply that the options were worth roughly $700,000 in total at the current valuation. Nobody explained the exercise cost.
Three years later the company agreed a sale at $30 per share. Staff were delighted until they discovered that exercising required real cash up front: an employee with 5,000 options needed $60,000 to buy shares that would then sell for $150,000. Several people did not have $60,000 available.
Verity's finance team arranged a cashless exercise through the buyer, where the sale and the exercise settled simultaneously so employees received the $90,000 net gain without funding the purchase themselves. The illustrative lesson is that an option scheme communicated only as a headline value, with no explanation of exercise mechanics or tax timing, creates avoidable anxiety at exactly the moment it should be paying off.
Watch out
Common mistakes.
- Treating an option grant as if it were the same as owning shares, when the holder owns nothing until the options vest and are exercised.
- Quoting the headline paper value of a grant without subtracting the exercise cost and the expected tax charge, which can leave people badly misled.
- Assuming options are cost-free to the company, when they create a share-based payment expense and dilute existing shareholders on exercise.
Questions
People also ask.
What happens to options if someone leaves?
Unvested options are almost always forfeited, and vested ones usually must be exercised within a short window, often 90 days, or they lapse.
What does underwater mean?
It means the market price sits below the exercise price, so exercising would cost more than buying on the open market and the option has no value unless the price recovers.
Are options the same as restricted stock units?
No, because restricted stock units are shares given outright once they vest and retain value at any positive share price, whereas options require payment of the strike price and only pay off above it.
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