Definition
A stock option is an agreement that gives a person the right to acquire shares of a company at a predetermined exercise price, subject to the terms of the option plan and grant.
In startups, stock options are commonly used as a form of employee or executive compensation. They can give employees an opportunity to benefit from future increases in the company's value without requiring them to purchase shares when the option is initially granted.
An option is not itself the same as owning the underlying shares. The holder generally becomes a shareholder only after exercising the option and acquiring the shares, subject to the applicable legal and plan terms.
How does a stock option work?
A simplified example:
Option grant: 10,000 options
Exercise price: $2 per share
Future share value: $10 per share
If the employee exercises all 10,000 options:
10,000 × $2 = $20,000
The employee pays $20,000 to acquire the shares.
If the shares are worth $10 each at that time:
10,000 × $10 = $100,000
The difference between the share value and exercise cost is:
$100,000 − $20,000 = $80,000
This is a simplified illustration. Actual economic value and tax treatment depend on the company's share value, liquidity, applicable rules, and the specific option structure.
Key terms associated with stock options
Exercise price
The exercise price, also called the strike price, is the price at which the option holder can purchase the underlying shares.
Vesting
Vesting determines when the holder earns the right to exercise the options.
Exercise
Exercise is the act of using the option to purchase the underlying shares.
Expiration
Options generally have a defined period during which they can be exercised, subject to the plan and applicable law.
Stock option vs. shares
These are not the same.
Shares:
Represent an actual ownership interest in the company.
Stock options:
Represent a contractual right to acquire shares under specified conditions.
For example, an employee may receive:
10,000 options
but does not necessarily own 10,000 shares immediately.
The employee may need to satisfy vesting conditions and exercise the options before becoming the holder of the underlying shares.
Why do startups use stock options?
Startups often use options to align employee incentives with long-term company performance.
Potential benefits include:
Attracting talent
Retaining employees
Aligning employee incentives with company value
Conserving cash compensation
Giving employees potential participation in future company value
This can be particularly relevant when a young company cannot compete with larger employers purely through salary.
Stock options and dilution
Stock options can contribute to future dilution because exercising options can result in additional shares being issued.
For example, a company has:
1,000,000 existing shares
and has:
100,000 outstanding options
If all relevant options are exercised, the share count could increase to:
1,100,000
The ownership percentage of existing shareholders would therefore decrease unless they also acquire additional shares.
This is one reason option pools and outstanding options are considered when analysing a company's fully diluted capitalisation.
Stock options and the employee option pool
Startups often establish an employee stock option pool to reserve equity for current and future employees.
For example, a company might establish a pool representing 10% of its fully diluted capitalisation.
Options can then be granted to employees from that pool.
The actual percentage represented by an employee's options depends on the company's total capitalisation and the number of shares or options outstanding.
Vesting and stock options
Options are commonly subject to vesting.
A four-year vesting schedule with a one-year cliff is a common structure, although terms vary.
Under a simplified example:
Grant: 10,000 options
Vesting period: 4 years
One-year cliff
The employee might receive no vested options until the first anniversary, after which a portion vests. The remainder then vests progressively over the remaining period.
The actual schedule is determined by the option agreement.
What happens when an employee leaves?
The treatment of unvested and vested options depends on the company's plan and the employee's agreement.
Generally:
Unvested options may be forfeited.
Vested options may remain exercisable for a specified period.
Some circumstances may result in different treatment.
The rules can vary substantially by jurisdiction and by the terms of the individual grant.
Stock options and private companies
Options can be particularly attractive in private startups because employees may receive exposure to potential future company value before there is a public market for the shares.
However, an option's potential value does not mean that the employee can necessarily sell the underlying shares.
Private-company equity can be subject to:
Transfer restrictions
Repurchase rights
Shareholder agreements
Lack of liquidity
Company approval requirements
Other contractual restrictions
Stock options and liquidity
An employee may hold valuable options on paper without having an immediate way to convert them into cash.
A potential liquidity event could include:
Acquisition
Initial public offering
Secondary transaction
Other company-approved liquidity mechanism
Until a liquidity opportunity exists, the economic value of private-company equity may remain uncertain.
Stock options and taxes
Tax treatment can differ substantially across jurisdictions and between different types of option plans.
Depending on the country and instrument, taxation may arise at:
Grant
Vesting
Exercise
Sale
Some jurisdictions provide specific tax-favoured employee equity schemes, while others do not.
Employees should therefore obtain jurisdiction-specific tax advice rather than assuming that an option has the same tax treatment everywhere.
Example
A startup grants an employee:
20,000 stock options
with an exercise price of:
$1 per share
The options vest over four years.
After three years, 15,000 options have vested.
The employee can potentially exercise those 15,000 options according to the terms of the plan.
If the relevant share value is then $6:
15,000 × $6 = $90,000
The exercise cost is:
15,000 × $1 = $15,000
The simplified difference is:
$75,000
This does not represent guaranteed cash value because the shares may remain illiquid and tax and other costs may apply.
Common misconception
Receiving stock options means you already own the shares.
No.
An option is a right to acquire shares, not necessarily the shares themselves.
Ownership generally arises when the option is exercised and the shares are issued or transferred, subject to the applicable legal and contractual arrangements.
