Author Topic: Can somebody explain to me what stock options are?  (Read 2263 times)

stache9434

  • 5 O'Clock Shadow
  • *
  • Posts: 11
Can somebody explain to me what stock options are?
« on: January 14, 2017, 04:11:33 PM »
I am being offered stock options, but from what I've read on the internet, they are very complicated and don't seem like that great of a deal. I would basically be buying a bunch of stock in a single company, right? Why should I do that instead of adding to my 401k?

MrsDinero

  • Pencil Stache
  • ****
  • Posts: 929
Re: Can somebody explain to me what stock options are?
« Reply #1 on: January 14, 2017, 04:33:05 PM »
Following because I'm researching it now.  My company is a startup so until (if) they go public no money is being made, I'm simply investing money in my company.

I found this article helpful
https://www.allbusiness.com/how-employee-stock-options-work-in-startup-companies-103450-1.html

geekette

  • Handlebar Stache
  • *****
  • Posts: 1824
Re: Can somebody explain to me what stock options are?
« Reply #2 on: January 14, 2017, 05:12:18 PM »
If your company is public, it can be quite profitable, but it depends on how they're priced and how quickly you can sell.  Do you have more details?

I don't have any experience with options for start ups.

StreetCat

  • 5 O'Clock Shadow
  • *
  • Posts: 81
Re: Can somebody explain to me what stock options are?
« Reply #3 on: January 14, 2017, 05:24:46 PM »
More details will help better answer your question.  Under what terms are the options being offered?

Some times companies offer options with a compelling structure.  For example, you may get options at the lowest price that the stock has been in the last year.  I've also heard terms where the option is offered at 3-5% discount to the stock's market value.  In cases like that it may be worthwhile to make use of options, even though you are purchasing options for only one company.

As per complexity, options aren't necessarily complex, although they can be.  It's like anything else I guess.  You can learn about them and make a wise decision.

seattlecyclone

  • Magnum Stache
  • ******
  • Posts: 4638
  • Age: 34
  • Location: Seattle, WA
Re: Can somebody explain to me what stock options are?
« Reply #4 on: January 14, 2017, 05:54:19 PM »
Options aren't terribly complicated. The company offers you the right to buy a certain number of shares at a certain price (typically the current share value) on a certain date in the future. That's all. The taxation bit can be a bit complicated depending on what type of option they are, but you can cross that bridge when you come to it.

You're right that you generally don't want to own lots of stock in your employer. That's not really how most employees should think of options. They're not there to make you a long-term owner, they're there to give you a financial benefit if the company grows. All that work you do before the option vests is hopefully adding on to the stock's value, and you get to share in that increase when your option vests. You'll generally exercise your options and sell shortly thereafter to avoid tying up too much of your wealth in your employer.

Laura33

  • Handlebar Stache
  • *****
  • Posts: 2208
  • Location: Mid-Atlantic
Re: Can somebody explain to me what stock options are?
« Reply #5 on: January 14, 2017, 07:01:35 PM »
"Options" are one of the few investment things that are actually named somewhat accurately -- it is an opportunity/choice ("option") to buy a certain amount of stock on a certain date at a certain price.  Usually companies give these more as a cash bonus/incentive and are not expecting you to hold them for a long time.  There are different types of options, so the specific details are critical.

Ex:  Day 1, As part of your bonus, the company gives you 100 options with a strike price (the amount you can buy the stock for) of $25, which vest in three years.  Three years later, the stock price is $20 -- so now you can exercise the options, but why would you, because you'd be paying $25 for stock that is worth $20.  Oh well, your bonus wasn't worth anything.  [note that the options usually remain good for some period of time, like a year, so you usually hang on and hope the stock price comes back; I am just trying to make it simple]

But more likely the stock is at $40.  So now you exercise your options -- which means you pay $2500 ($25 x 100 shares) to buy shares that are now worth $4,000.  Woo-hoo!!  Free money!!  Usually, you can then immediately sell the stock to net that fat $1500 profit (note that this also prevents you from owning too much stock in your employer, because you're selling it as soon as you buy it).  Some people choose to hang on to the stock and see what happens, because you pay a lower tax rate if you own the stock for a year before selling, but that means you can also lose money if the share price drops.  But the point is that now you own the actual stock and can buy or sell as you choose.

Another kind of "option" is really just a disguised bonus.  DH gets options every year that vest in 3 years, again tied to a specific stock price.  But he never gives them any money -- when the day comes to exercise the options, the company basically gives him the delta as cash (so in the example above, instead of him giving them $2,500 and receiving $4K in stock, they basically wriite him a check for $2500).

Tl;dr:   if they are offering to give you options, this is a good thing, because at worst they are worth nothing, and if the stock price is higher when your options vest, you can exercise the options and immediately sell the stock to lock in your gains.  OTOH, I would not actually pay any money to buy options -- that is a level of sophisticated investing that I am not personally comfortable with.

Indio

  • Bristles
  • ***
  • Posts: 304
Re: Can somebody explain to me what stock options are?
« Reply #6 on: January 14, 2017, 07:58:13 PM »
Options can also be granted to non publicly traded companies and these may be available at a lower strike than if it was traded on the stock exchange or depending upon the timeframe the options were granted. There are certain types of options that can be more lucrative than those available for employees at public companies. For example, your options, if privately held start up company, may throw off a bonus or dividend payment if the board or equity investors want to take cash out of the business. You need to know what class of options and what the vesting schedule is for them. If you are a new employee and not on commission,  these may be given to you as a way to retain you over the long haul so they may vest a certain percentage every year. You need to read the fine print closely.

Anyway, I would not say that all options are a bad idea. you just need to understand what the terms are for the different types of available options. Not all options will actually cost you anything out of pocket. If you have options as part of an employee purchase plan, this would be another way for you to buy a stake in your company's success. Another poster described it in detail above.

 Options and 401k are two different beasts entirely so understand the differences before you decline the options. Ask questions till you understand what is being offered. After all that is the best way to learn.

Goldielocks

  • Walrus Stache
  • *******
  • Posts: 6002
  • Location: BC
Re: Can somebody explain to me what stock options are?
« Reply #7 on: January 14, 2017, 08:11:15 PM »
Great Answers above!  I wanted to try to reply with a simple example.

You are granted stock options as follows:

The right to buy 3000 shares at today's stock price of $20.
They vest at 1000 each year.  You can't sell until that portion has vested.

You give ZERO money upfront.

In one year, the first 1000 shares "vest" and you have the OPTION to buy them at $20, even though they are now worth $22.
You can buy them, (called EXERCISE your option) or defer that decision until later.
--> if you buy them, you pay $20 per share, or $20,000 and can hold onto the Shares, and sell them later.  Very few people do this!  Risky for the amount of money involved.   
-->  OR you can do a cashless exercise, and sell them immediately, and you would then be given cash of $22 - $20 x 1000 shares = $2000 in your pocket (from which taxes are taken).  This is the opportunity and the benefit

If the share drops BELOW the $20 buy option price, after a year, you just ignore and have ZERO dollars out of pocket.


NOTE -- you pay taxes on the gain in value of any options you exercise (NET value gain). 
---You can defer the decision for many years until the option to buy expires, and NEVER PAY ANYTHING until you are in the money.





« Last Edit: January 15, 2017, 12:31:55 PM by Goldielocks »

Reynolds531

  • Bristles
  • ***
  • Posts: 292
Re: Can somebody explain to me what stock options are?
« Reply #8 on: January 14, 2017, 08:17:19 PM »
Many years ago I administered the McDonald's Canada executive stock option plan. This thread brings back memories of the 90s!

geekette

  • Handlebar Stache
  • *****
  • Posts: 1824
Re: Can somebody explain to me what stock options are?
« Reply #9 on: January 14, 2017, 08:36:07 PM »
Deleted - blame late night brain and read the post below...
« Last Edit: January 15, 2017, 08:41:51 AM by geekette »

tonycar17

  • 5 O'Clock Shadow
  • *
  • Posts: 19
Re: Can somebody explain to me what stock options are?
« Reply #10 on: January 15, 2017, 08:15:24 AM »
OP, my experience tells me there are really 3 main types of benefits that are related to company stock and I will start with your question - Stock Options:

1.  Stock Options.  When given options, the company gives you a set number of shares that you are given the choice (option) to buy at some point in the future.  In most companies, these "vest" over a certain numbers of years (3 or 4 is my experience).  This is a "waiting period" where you do not have actual access to do anything with all or a portion of the stock.  An example will likely help:

Today, your company gives you 300 shares at a strike (option) price of $20.  They vest over three years, meaning 1 year from now, you are able to exercise the option to buy 100 of them.  A year after that, the next 100 becomes available, and then next year, the final 100 become available.  In almost all cases, you have a TOTAL WINDOW of 10 years to make a choice to exercise. 

Let's say in Year 5, price is now $50 per share.  You can exercise your "option" to buy all 300 (or any part of the 300) for $20 per share.  Most people do not exercise their option and then hold the stock - they exercise and sell immediately, in a cashless transaction as described by a prior poster above.  In this case, if you exercise all 300 options, you would have a gross amount of $15,000 and subtract the option purchase price of $6,000 (300 shares X $20 option price) for a net of $9,000.  This would, in today's tax world, be taxed at long term capital gains rates - likely 15%.  If you only exercised a portion of your options, the math changes but the concept does not.

2.  Restricted Stock Units (RSU's).  These are "better" stock incentives in my opinion because they are stock that is simply given to you on a vesting schedule (you do not have to "buy" them).  Same example as above - you are given 300 RSU's today with a strike price of $20, with 100 each vesting the next 3 years. 

At the end of year 1, you are given 100 shares of the company stock at whatever price it is at on that day - let's say $30.  Important to note here that the ENTIRE amount (100 shares X $30 per share) is considered taxable as income in the year in which the RSU is granted.  If you hold onto it, you have a further tax event later on once you sell where you would be subject to either short term or long term capital gains based on the difference in price between the $30 and whatever you sell it at. 

3.  Employee Stock Purchase Plans.  These are what geekette mentions above - money is taken our of your paycheck over the course of a period (usually 6 months) and then on a specific date, stock is purchased and you are given a discount from the price on that date (usually 15%).  Some plans (including the one I participate in) allows the company to give you a discount on the stock price at EITHER the beginning of the purchase period or the end.  Example below:

Beginning period stock price = $20
Ending period stock price = $30
Employee paycheck deduction = $100 over 13 pay periods ($1300)

At the end of the period, the employee has $1300 that will be used to purchase stock.  The stock will be purchased at a 15% discount of the beginning price, since it is lower.  So the purchase price is $17 per share (15% discount from beginning price) that the employee gets 76.47 shares ($1300/$17 per share).  The employee can immediately sell for the gain - 76.47 X current price of $30, or $2294.10.  This would trigger a taxable event at the individual's tax rate of $994.10 (2294.10 sales price minus the $1300 initial investment).  If the individual holds the stock for at least a year, it would get preferential tax treatment of long term capital gains rates.  The risk there is you do not know what the stock price will do in the next year.....

OK, hopefully that is helpful.  What you are describing in OP are #1, but thought I would provide some addition info on the other things that have been mentioned here as well.

TC