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The ABCs of ESOs
In Lesson 10
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Money 101 Lessons
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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 percent 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 percent of the total shares are exercisable after one year, another 20 percent 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.
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