What it means
A company grants options as part of pay, often to executives, key staff or everyone in a start-up. The employee does not receive shares on day one.
Instead, they receive the right to buy shares later at a price fixed at the time of the grant, which is usually the market price on that date. Most options vest, meaning they become exercisable gradually.
A common arrangement is for a quarter of the options to vest each year over four years, so that an employee who leaves early gives up the unvested part. Many plans also include a cliff, where nothing vests until the first anniversary.
Once options have vested, the employee can exercise them by paying the strike price. If the market price is higher than the strike price, the option has intrinsic value (the built-in profit).
If the market price stays below the strike price, the option is described as underwater and has no immediate worth, although it may regain value if the price recovers. For the company, options are an expense.
Accounting standards generally require the estimated fair value of the options at the grant date to be spread over the vesting period as a cost in the income statement. Valuation commonly uses option pricing models, which take into account the share price, strike price, time, volatility and interest rates.
Tax treatment varies by country and by the type of option. In some places, tax is due when options are exercised, and in others, it is due when the shares are sold, or both.
Employees should take advice before exercising, because the tax bill can arrive before the shares have been sold for cash. Options also dilute existing shareholders, since exercising them creates new shares.
Investors therefore look at the number of options outstanding and treat them as a cost of the business. Some companies buy back shares to offset the dilution.
In practice
Real-world examples.
Example
A start-up grants a new engineer 20,000 options at a strike price of $2, vesting over four years. After two years, 10,000 have vested. She leaves, keeps the vested options for a limited period and gives up the rest.
Example
A listed retailer grants its finance director 50,000 options at the current share price of $30. The options vest in three years if profit targets are met. The board uses this to link his pay to company performance.
Example
A manufacturing firm offers options to all its 200 staff to encourage loyalty. After the share price falls well below the strike price, the options are underwater. The company discusses whether to reprice them, though shareholders may object.
Formula
Calculation
Intrinsic value = (Market price - Strike price) x Number of options
Worked example: An employee holds 5,000 vested options with a strike price of $10. The shares now trade at $25.
Gain per option = $25 - $10 = $15
Intrinsic value = $15 x 5,000 = $75,000
To exercise, she pays 5,000 x $10 = $50,000 and receives shares worth 5,000 x $25 = $125,000, so the gain is $75,000 before tax.Case study
Seen in the real world.
Brightspark Software is an illustrative, fictional company that could not afford high salaries in its early years. The founders granted each of its first ten employees options over 1% of the company, priced at $1 per share.
Over five years, the business grew and was eventually sold. Employees who had stayed for the full vesting period exercised their options and sold their shares at $9, receiving a gain of $8 per share on each option.
In this illustrative story, one early engineer held 50,000 options and made $400,000 before tax. Others who had left in the first year gained nothing from the unvested part. The founders concluded that options had helped retain staff, but that the plan needed clearer communication about how the gains and taxes worked.
Watch out
Common mistakes.
- Treating options as free money, when the employee must pay the strike price and may face a tax bill on exercise.
- Ignoring the expiry date, when options not exercised in time can lapse and become worthless.
- Assuming unvested options stay after leaving the company, when unvested options are usually forfeited.
Questions
People also ask.
What is the difference between an option and a share?
An option is a right to buy a share later at a fixed price, while a share is actual ownership of part of the company.
What does underwater mean?
An option is underwater when the market price is below the strike price, so exercising it would cost more than the shares are worth.
Do options cost the company anything?
Yes, the estimated fair value is recorded as an expense over the vesting period, and exercising options dilutes other shareholders.
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