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Important Stock Option Terminology and Concepts
This information was graciously provided by Richard Wood of Kirkpatrick & Lockhart LLP, who isn't responsible for anything you do with it (see our disclaimer).
What is stock?
Stock represents legal ownership of a portion of the income and assets of a corporation.
What is a stock option?
A stock option is a legal contract that gives the holder the right to buy a fixed number of shares of the employer's stock at a fixed price that may be exercised during a fixed period of time.
What is the "grant" of stock option?
A stock option is granted when the employer, usually through action of its Board of Directors, sets the number of shares, exercise price and duration of the option. But the option contract can state a later effective date for the option.
What is the exercise price and how is it set?
The exercise price (sometimes called the "strike price") is how much the option holder must pay to buy the optioned stock. Usually (but not always) the exercise price equals the value of the optioned stock on the date the option is granted.
Why are options valuable to employees?
If the value of the stock increases after the date of grant so that it becomes greater than the exercise price, the employees can buy the stock at a lower price (the exercise price) than other investors must pay (the market price). They can then sell the stock for cash and realize a profit.
After the grant, is the option holder a shareholder?
The holder of a stock option generally has none of the rights of a shareholder like voting or dividend rights unless and until the stock option is exercised and the stock is issued.
What is the exercise of an option?
The exercise of an option occurs when the option holder pays the exercise price and buys the shares. At that point, shares of stock are actually registered in the option holder's name and shareholder status begins.
What is vesting?
Stock options are almost always granted subject to a vesting requirement. This means that certain conditions must be met before the option becomes exercisable and the employee can actually buy the shares. In most cases, vesting occurs just due to continued employment ("time-based" vesting), but in some cases vesting requires that individual or company performance goals be attained ("performance-based" vesting).
How long do options last?
All stock options have a stated exercise period, which is the period of time within which the option must be exercised. If the option is not exercised within this period, the option expires. Ten years is the most common exercise period for employee options.
In most option plans for employees, an employee's option exercise period can be cut short if employment terminates. In some cases, option plans provide that all options just automatically expire when the employee terminates employment. Other plans allow the options to continue for a short period after termination - like 90 days - or make exceptions for certain types of terminations, like death, disability, or retirement.
How are options exercised?
The normal way for an employee to actually exercise his or her option after it becomes vested is to pay the exercise price to the employer by check. Some plans allow employees to pay the exercise price in forms other than cash. For example, companies can loan the exercise amount to the employee or the employee may be permitted to pay the exercise price by delivering previously-acquired shares of employer stock.
What is the option "spread?"
The "spread" is the excess of the value of the option stock over the option exercise price. For example, if the exercise price is $10 per share and the current value of the stock is $25 per share, the spread is $15 per share.
What are "in-the-money," "out-of-the-money" and "at-the-money" options?
An option is "in-the-money" if the value of the stock is greater than the exercise price (i.e., the spread is a positive number).
An option is "out-of-the-money" if the value of the stock is less than the exercise price m(i.e., the spread is a negative number).
An option is "at-the-money" if the value of the stock equals the exercise price (i.e., the spread is zero).
What if my employer’s stock is not publicly traded?
In many ways, the option programs of privately-held companies are the same as those of public companies. The obvious difference is that when an employee of a private company exercises an option and buys the stock, he or she does not have a ready market for the stock. How can the employee of a privately-held company profit on the option?
Some private companies will agree to buy the stock from the employee, particularly if the employee is terminating employment. In other cases, the employee must wait for some significant event to occur, like an initial public offering (IPO) or sale of the company, before realizing a profit.