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Everything You Need To Know About Stock Options

by Don Rainey

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If you’re joining a company or have been offered stock options at your current job, there are some things you should understand about stock options if you want to negotiate effectively.

The complexity of an accompanying “Employee Stock Plan” and the formality of a stock option offer can be off-putting.   But, you don’t have to know a lot to be effective in stock option negotiation.    If you have command of how much options are worth, what is fair in terms of option amount, the nature of key terms, potential tax liability, and the power of now, you will be positioned to make the best deal you can.

Understand the math

First thing's first, look at the options themselves.  The stock options cannot be understood without knowing the "entire fraction" -- that is to say that options offered to you are the numerator of a fraction.  Knowledge of the whole fraction, (the numerator as well as the denominator), is the starting point for evaluating a stock option.

To be explicit, having 3,000 stock option shares in a company with 30,000 total shares is having 10%.   So, if you are offered 200 stock options in a company with 30 million shares, it’s nice but it may not be all that profitable.  Here again, the value of the shares is the ultimate determinant of value but you can't discern too much of anything based upon the raw number of options (the numerator alone).

Know what is fair

Most companies establish acceptable stock option grant ranges for certain positions and associated salaries.   What is the range for your position and where are you in that range?  What would it take to get above the range?  If the answer is you can’t be offered an amount of options outside the pre-determined range, push back on the salary as a negotiating technique.    Either way, seek whatever is fair and appropriate to the position.

If you’re considering an executive position at a company with existing initial investors, be aware the company will also need to support a CEO, three VP's and five to seven directors with incentive stock options from the stock option pool.  While circumstances vary widely to affect the proper amount of options associated with an executive position, the general consensus for various positions is the following:

CEO  -  Option Grant of 4 to 8%
VP's  -   Options of 2 to 3%
CFO -    Options of 1to 3%
Directors - Options of 1/2% or less

Founder CEOs with shares or other particular facts may influence these numbers and all generalizations are dangerous.  The right amount for any situation is, and should be, the focus of a fair amount of discussion.

Comprehend the key terms

The key terms with stock options relate to the price and vesting of the options.   What the price is can be relatively straightforward while how the price is determined is not.   More on that in a moment.

Vesting means that you earn the right to buy the options over a period of time. Your right vests over time. For example, if the stock option specifies you get 1,000 stock options priced at $1.00 with a vesting period of four years, you can buy 250 shares annually for four years.   You don’t have to buy them then, but you have the right to buy them then.   If you stay in the employ of the granting company, you may have the right to buy the vested options over  5, 7 or 10 years.  You should know the vesting schedule and how long you can buy your vested options.

The price of a stock option is another matter.   Stock options are designed and intended by most companies to be valueless on the day they are granted so they don’t create a taxable event in the eyes of the Internal Revenue Service.   If you were granted 1,000 shares priced at $2.00, for example, when the fair market value was really $5.00 per share – the I.R.S. views the difference of $3,000 as taxable income.

So the fair market value of the option on the date of the grant is important.  (Which is why most stock option scandals relate to “back dating” the options to hide the income effect of granting options priced lower than fair market value).  But how does one determine the fair market value of a private company stock option that by definition isn’t sold in any open or efficient stock market?

It can be tough to do well and some specialty financial firms exist almost solely to provide that answer for a fee.   In any case, your questions need to be oriented to the timing and source of the valuation.  Remember if the options are priced incorrectly, you will personally owe the taxes.   The I.R.S. reserves the right of 20/20 hindsight on this pricing event.   The company will also be liable for incorrect pricing.    What you need to determine is that a professional effort was made to correctly price the options.   For a public company employee receiving options, this is much simpler because the pricing is determined by  the closing price of the stock on the date of the option grant.

Be ready to pay the taxes

The premise underlying stock option value is that you will be able to buy the stock in the future at today’s lower price.   And yes, when you actually buy the option or “exercise it”, you are liable for the taxes associated with the profit income.  So if you exercise 250 shares at $1 by purchasing  the option for a stock that is worth $5 per share, your income from a tax point of view is the $1,000 profit total from the $4 profit per share. This is true even if you don’t turn around and sell these shares as soon as you purchase them.  

There are many tales of woe around people buying stock at $1 when it is worth $5 and waiting to sell the shares, only to sell at $3 per share. In this example, the taxes are determined from the paper profit regardless of the actual profit. Does this mean that you should sell the option on the day you exercise it?   For most people, the short answer is yes. In any case, one should understand the taxable event and liability. And be ready to pay.

Be aware of the moment

If your options become more valuable over time, tomorrow’s options will become scarcer and harder for you to get more of as a result. So the moment to get stock options is always now. Tomorrow’s options should be, if things are going well, higher priced. There will be fewer to give away because the original amount of shares set aside for option grants tends to diminish over time.

Yes, the company could just simply issue or create more shares for option grants but you need to realize that doing so decreases the value of all existing shares.   And remember that the people that need to support the additional share creation are the shareholders who will in fact be hurt by the decrease in share value.  The short answer is that everyone acts in their economic self interes,t and as options become more valuable, they become harder for employees to get.

Stock options have been a material wealth source for the employees of many companies.  For most people, they are an arcane subject if not an apparently complex one.   But given the money at stake, having a working understanding of the issues and dynamics is well worth the time.