Stock options are a form of compensation and incentive, which is typically given to executive staff and key personal, at most companies. For those of you that are not familiar with how it works I will give a quick overview of the salient points. All of this is covered more formally in the long required legal document but this should be considerably easier to read and comprehend.
The stock option deal is very simple in principal and very complicated in legal details (because it has to do with money, and where there is money, there is a government looking for taxes and there are also crooks looking to bilk little old ladies out of their nest egg) This is the simple story.
Stock is ownership of a company. The value of the stock floats up and down with the value of the company. When a company does well (increasing revenues) the stock usually does well. When the company is screwing up, the stock price goes down. It is generally a good idea to have the people that work for the company to have some ownership in the company. This is not altruism, it is in the self interest of the company. The people working for the company can directly influence the success of the company. They will have a greater incentive to do the right things to make the company successful if they have some way of sharing in the success. This is similar to giving a commission to a salesperson, the more money that they bring in, the more they personally make. If your organization has some longer-term goals, like growing the infrastructure to enable web-based sales of music, the compensation is glued to something longer-term like stock.
So the company wants to give the employee some stock as compensation, because the company wants the employee to think longer term. The company wants the employee not to look at the job as just a way to put in another week and pick up another check, but rather to be looking for things that will make the company more successful. Salary is short-term compensation, Stock is long term compensation.
Legally there are problems with just giving the employee stock for nothing. It is not fair to the other owners of the company and it does not reflect that the stock has value so instead the stock must be sold to the employee for the “fair market value” (this is the term for the value of the stock, I will get back to this later on when I get into Public versus Private companies)
There is also a problem with selling you stock. The problem is that most employees don’t have the cash to buy the stock and perhaps have some doubts as to its worth. It is not an incentive if no one takes you up on it.
The solution is a tried and true method with a long legal history, the “incentive stock plan” or “stock options”. Stock options are better than stock. If I sell you 100 shares for 5$ each, you would give me the 500$ and I give you the shares and then the value of those shares float up and down with the worth of the company. Instead I give you an Option to buy those 100 shares from me at some later date, say 5 years from now, for that same 5$ per share.
What this means is that you don’t need to decide today what you want to do, instead you wait. If the company goes up in value, say to 25$ per share, then you can exercise your option (meaning you take us up on the deal) You give us the 500$, buy the 100 shares, which are worth 2,500$. You just made 2000$ (and for the record you owe taxes on the money you just made). In reality, you don’t even need to cough up the 500$, more typically the company gives the 100 shares to a broker who sells 20 of them to raise 500$ which the broker gives to the company for their option price and then gives the 80 remaining shares to you. The cool thing about doing it this way is that you did not just make 2000 dollars, you just got 80 shares worth 2000 dollars. The reason that that is cool is that you are not taxed for stock, only for money. Granted you will eventually have to pay tax whenever you finally sell the stock and make your money, but you get to decide when and how you want to do that.
The most excellent thing about stock options is that it is a NO LOSE proposition (note luck has no part in this, you simply can not lose money on a stock option!). If the value of the company went down in those 5 years, say to a value of 3$ per share, you simply do not exercise your option. Since there is no point in you paying 5$ per share to get something worth only 3$ per share you just let the option expire and do nothing. It costs you nothing.
What a deal, if it goes up you win, if it goes down you do NOT lose. This is different from owning the stock directly where when it goes up you win and when it goes down you do lose.
So we give you stock options, and now you have an incentive to make the company increase in value long term so that the stock will be worth something at the expiration date when you will decide whether or not to exercise. (The decision is trivial. If the stock is worth more than the option price, you exercise, if not, you let it drop)
There is one problem for the company in that scenario, the employee says, “Cool, now I have a stock option, I can’t lose, I can only win, I’m outta here! Let those other dudes make the company more valuable and I’ll just pick up the winnings at the end!”
The fix is simple, we don’t actually GIVE you the option all at one time. Instead, the company trickles it out slowly over the next five years. That is, we give you the option to buy 100 shares at 5$ per share, but those 100 shares are doled out in chunks at vesting periods. It works like this. The employee must stay with the company for a year and at the end of the year you have “vested” 20 of those 100 shares. If you stay 1 more year, you will vest another 20 shares. If you decide to quit right then, you MUST make your exercise decision RIGHT THEN and you ONLY get to buy the 40 shares that you have vested, not the full 100. If you want the full 100 you MUST stay with the company (presumably working hard) for the full 5 years. At the end of 5 years you will have vested all 100 options and can exercise the whole batch.
All stock option programs work in this basic way (it is legally controlled by tax and securities law, i.e. companies get tax breaks if they do it exactly according to the plan and get to sit behind bars if they do it some other way)
“Stock options” means you have an option to buy stock at a fixed price at some time in the future, not the stock itself. You have a strike price, or an option price, which is how much you will have to pay IF you eventually exercise. You have a vesting schedule, which is the rate at which little chunks of the option (not the stock) will be dribbled out to you. And you have an exercise date which is the time that you must actually make the decision (normally the exercise date comes sometime, like months or even years, after the last vesting date to give you time to go talk to your accountant)
Stock options are referred to as “the Golden Handcuffs” The point being that their purpose it to bind you to the company, to make it difficult for you to leave. However the means of binding is not some negative restraint, but rather the positive attraction of GOLD. If you stay just a little bit longer and work a little bit harder you can get more of the gold. You will be free to leave at anytime, you just won’t want to.
If you followed this, you should now have no trouble reading the long legal document that gives all the grubby details, however the most important point is this. Stock options really are a NO LOSE situation. When you sign the papers, you are not obligating yourself to anything. You don’t need to do anything with the options if you do not want to. You do not need to ever pay any money and you do not need to stay with the company. You only need to stay with the company if you want to get rich beyond all your wildest dreams of avarice.
Oh, yes. One other useful legal distinction you should know, the difference between a public and a private company. Disney is public. Any random dude on the street can call up a broker and buy or sell Disney stock. It is publicly traded. In order to become a public company Disney had to jump through a bunch of legal hoops, prove that they do their accounting in certain specific ways and prove to the security and exchange commission that they are not just a bunch of crooks out to bilk little old ladies out of their money. When all the hoop jumping was done Disney had an IPO, Initial Public Offering (of stock). That is called “going public”
Once a company is public the price of the shares is set by market forces, i.e. It is whatever people are willing to pay for it. Before that time the price is set by the board of directors of the company. It is in the interests of the board to determine a “fair market value” at a time when there is no market. Until the company goes public it is ILLEGAL for the company to sell stock except under very controlled conditions, like raising money from a venture capitalist. The laws are there to prevent me from enticing little old ladies to pour all their savings into some risky venture like trying to sell sheet music over the Internet.
Legal disclaimer: I am NOT a financial consultant nor am I a lawyer and am NOT giving either financial or legal advice. I am not promising that you will ever be rich. The ONLY contract that we have concerning stock and stock options is that which is contained in the official legal document which is full of all kinds of legal disclaimers. People are REALLY touchy about money. Actual mileage may vary, etc etc. This is just chit chat around the water cooler to help you read the legal document. You will notice that no where in this document is the company name mentioned and the company does not warrant that any information in this document is correct. Let the buyer beware.
Boy, do I ever hate legal requirements.