Money Essentials

Employee stock option tips and tactics

Make sure you know the ABCs to your ESOs


An employee stock option is the right given to you by your employer to buy ("exercise") a certain number of shares of company stock at a pre-set price (the "grant," "strike" or "exercise" price) over a certain period of time (the "exercise period").

Most options are granted on publicly traded stock, but it is possible for privately held companies to design similar plans using their own pricing methods.

Usually the strike price is equal to the stock's market value at the time the option is granted but not always. It can be lower or higher than that, depending on the type of option. In the case of private company options, the strike price is often based on the price of shares at the company's most recent funding round.

Employees profit if they can sell their stock for more than they paid at exercise. The National Center for Employee Ownership estimates that employees covered by broad-based stock option plans receive an amount equal to between 12 and 20% of their salaries from the "spread" between what they pay for their option stock and what they sell it for.

Most stock options have an exercise period of 10 years. This is the maximum amount of time during which the shares may be purchased, or the option "exercised." Restrictions inside this period are prescribed by a "vesting" schedule, which sets the minimum amount of time that must be met before exercise.

With some option grants, all shares vest after just one year. With most, however, some sort of graduated vesting scheme comes into play: For example, 20% of the total shares are exercisable after one year, another 20% after two years and so on.

This is known as staggered, or "phased," vesting. Most options are fully vested after the third or fourth year, according to a recent survey by consultants Watson Wyatt Worldwide.

Whenever the stock's market value is greater than the option price, the option is said to be "in the money." Conversely, if the market value is less than the option price, the option is said to be "out of the money," or "under water."

During times of stock market volatility, a company may reprice its options, allowing employees to exchange underwater options for ones that are in the money. For example, if options were originally exercisable at $50, and the stock's market price dropped to $30, the company could cancel the first option grant and issue new options exercisable at the new $30 share price.

Does that sound like cheating? Maybe, but it's perfectly legal. Outside investors, however, generally frown upon the practice - after all, they have no repricing opportunity when the value of their own shares drops.

glossary
Glossary
take the test
Take
the test
more lessons
More Money Essentials
lessons
Features
They're hiring!These Fortune 100 employers have at least 350 openings each. What are they looking for in a new hire? More
If the Fortune 500 were a country...It would be the world's second-biggest economy. See how big companies' sales stack up against GDP over the past decade. More
Sponsored By:
More Galleries
6 luxury getaways to escape your digital life Step away from your smartphone. No Facebook or Twitter here. These are six places where luxury travel agents send clients looking to unplug and experience the ultimate digital-detox getaway. More
Most reliable cars - Consumer Reports These cars, trucks and SUVs scored best in the magazine's latest survey of vehicle owners. More
Some Converse copycats cost big bucks A few bargain brands got swept up in Chuck Taylor's net, but others cost a pretty penny. More

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.