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Understanding Your Employee Stock Options

When you receive a job offer to work at a private company, you may also receive stock options. This offer can be exciting, especially at a lucrative startup or highly valued tech company. But understanding these options is necessary to ascertain whether this offer is attractive or not. The real value of a stock option lies in the percentage the stock options represent in the company and how quickly they vest.

What Is an Employee Stock Option?

An employee stock option is the right to purchase a share of company stock in the future for the exercise price. The grant price is the price at which the stock option is offered, which is usually the same price as the stock’s fair market value. If the stock value goes up, then the option gains value as the purchaser (known as optionee) can buy the stock at a lower exercise price.

Having a stock option plan enables companies to share their ownership and profits with employees, thus rewarding excellent performance and motivating their employees to stay. Options also help smaller companies retain cash while providing their employees ownership in future growth potential.

Below are some important questions to consider when evaluating a stock option offer from a company you are looking to join or that has recently hired you.

1. What Percentage of the Company Does Your Stock Option(s) Represent?

A company could offer 100,000 options for several million shares on one end of the spectrum or offer less than 10,000 options for just one million shares on the other end. The second company’s offer is clearly a better one as the individual stock option is much higher. Knowing the actual value of your stock option in terms of the percentage of the company is very important.

2. Types of Shares Offered

When you calculate the percentage value, does it include all the company shares? Sometimes, companies do not share the full range of their stocks, thus making it appear that your stock options represent a greater percentage of the company than they really do. Be sure to get the full picture. Company stocks can include common stock or restricted stock units (RSU), preferred stock, options outstanding, unissued shares remaining in the option pool and warrants. A company that hides this information is often undergoing some internal troubles. (For related reading, see: Get the Most out of Employee Stock Options.)

3. What Is the Market Rate for the Position?

Every job has an ongoing market rate for both its pay and shares. It is okay to check in with your employer about the compensation rate for your position. A market rate can be influenced by the functions of your job and other factors such as seniority, location, management of other employees required and more.

4. Compare Your Option Grant to the Existing Marketplace 

Does your option compare well? Typically a company provides option grants relative to the market, where they either offer higher compensation for less equity or vice-versa. Often more successful companies provide less percentile because their success is expected. Check your offer in terms of your specific company in context.

5. Look at the Vesting Schedule

Often a vesting schedule is a four-year period with a cliff period of one year, which means you would not receive anything if you left within a year. After the cliff period finishes, you could vest up to 25% of your shares annually. This is a standard process; be wary of companies that diverge too far away from this process with longer periods of time required or other strange requirements.

6. If You Leave Before Your Vesting Schedule Ends

In most scenarios, you would get to keep the amount you had vested as long as you exercised them within three months of exiting. It is important to check on this policy with your company as your stock options could be worthless if you left after two or three years, before the vesting schedule had finished. 

7. Exercising Stock Options Early 

Sometimes you can exercise your stock options early before you have vested them. Typically, this is available only to the first employees of a new company. This can offer some tax savings as your capital gains can be taxed at a different rate.

8. Is the Company Being Acquired?

Does your company offer accelerated vesting? Some companies will provide you several months of vesting if you lose your job when the company is acquired. Layoffs can occur during acquisitions. For the company, offering this may result in a lower price for the company at acquisition because the new owner would have to provide additional options to cover the employees who left early. However, this can be beneficial to you as an the employee. 

Understanding employee stock options can help you determine whether or not a company's offer is fair compensation for the position you are considering or if you need to renegotiate before accepting it.

(For more from this author, see: 10 Common Investing Questions Answered.)