What it means
The mechanics are straightforward once the vocabulary is clear. You are granted options at a strike price, they vest over time, and after vesting you may exercise them by paying the strike price to receive the underlying shares.
Options are geared, and that cuts both ways. A share rising from $10 to $15 gains 50%, but an option with a $10 strike goes from nothing to $5 of value, so employee outcomes swing far more violently than shareholder outcomes.
That gearing is precisely the attraction for a young company. Options let a business that cannot match large salaries offer a genuine share in future upside, conserving cash while aligning staff with long-term value creation.
Tax treatment depends heavily on the scheme and the country, and it is where the most expensive errors occur. Some government-approved schemes tax only the eventual capital gain, whereas unapproved options are commonly taxed as employment income on the gain at exercise.
Companies must record an expense for options based on their fair value at grant, estimated with a model such as Black-Scholes and spread across the vesting period. The expense is real even though no cash leaves the business, and the eventual share issue dilutes existing owners.
Options go underwater when the share price falls below the strike, at which point they motivate nobody. Boards sometimes respond by repricing or issuing fresh grants, a move shareholders often resist because it rewards staff after a falling share price.
In practice
Real-world examples.
Example
An early employee at a private technology company receives 20,000 options with a $0.50 strike. Five years later the company is acquired at $9.00 a share, and after paying $10,000 to exercise, the employee receives $180,000 before tax.
Example
A listed retailer grants performance options to its executive team, exercisable only if earnings per share grows at least 5% a year for three years. Growth comes in at 3%, so the options lapse entirely and the accrued expense is reversed.
Example
A biotechnology firm's share price falls from $14 to $5 after a trial setback, leaving every outstanding option with a $12 strike deep underwater. The board issues a fresh grant at the lower price, and two large shareholders vote against the resolution.
Think of it
“Stock options let you buy company stock later at today's price-valuable if the stock goes up.
Formula
Calculation
Intrinsic value at exercise = (market price - strike price) x number of options.
Exercise cost = strike price x number of options.
An employee holds 10,000 vested options with a strike price of $8, and the shares now trade at $20. Exercising costs 10,000 x $8 = $80,000. The shares received are worth 10,000 x $20 = $200,000, so the intrinsic gain is $200,000 - $80,000 = $120,000, which matches ($20 - $8) x 10,000. Under an unapproved scheme taxed at exercise, income tax at 40% on that gain would be $120,000 x 0.40 = $48,000, leaving $72,000 before any later capital gains. Selling enough shares to cover both the exercise cost and the tax means selling ($80,000 + $48,000) / $20 = 6,400 shares, leaving the employee holding 3,600 shares worth $72,000.Case study
Seen in the real world.
Aldermere Robotics is a fictional engineering company used here purely for illustration. To recruit senior staff on modest salaries, it granted every one of its first 30 employees options with a $2 strike price and a four-year vesting schedule.
Seven years later the company was acquired at $18 a share. Employees who had stayed and exercised made $16 a share before tax, but four leavers discovered their vested options had lapsed 90 days after their departure because nobody had explained the exercise window, and one had left three weeks before a large tranche vested.
The acquiring group used the episode to redesign its own plan, extending the post-departure exercise window to twelve months and sending every option holder an annual statement showing vested amounts, strike price and deadlines. In this illustrative story the underlying economics were unchanged, and the difference came entirely from communication.
Watch out
Common mistakes.
- Valuing an option grant as though it were equal to the full market value of the shares, when only the gain above the strike price is ever worth anything.
- Forgetting that exercising requires real cash for both the strike price and any tax due, which can be a large bill before a single share is sold.
- Ignoring the exercise deadline after leaving a company, which is commonly just 90 days and causes vested options to lapse unused.
Questions
People also ask.
What does it mean for options to be underwater?
It means the share price sits below the strike price, so exercising would cost more than the shares are worth and the options have no current value.
How do stock options differ from restricted stock units?
Options require paying a strike price and are worthless below it, while RSUs are granted at no cost and keep value as long as the share price is above zero.
Why do companies expense options if no cash is paid?
Because the grant transfers real value to employees and dilutes existing shareholders, so accounting rules require the fair value at grant to be charged to profit over the vesting period.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%