When Stock Options are an Option

In the heady days that marked the 1990s dot-com boom, employee stock options functioned as an almost magical currency between eager would-be employees and their entrepreneurial employers. The appeal of such stock options was apparent to both parties; employees were eager to get a piece of the financial action being generated by what in hindsight was most definitely “irrational exuberance”. On the other hand, employers wishing to hedge their bets could pay less up front in the form of salaries by promising later returns to employees in the event that the fledgling company took off.

The strategy held further appeal by closely tying the financial well-being of employees to that of the company, thus ensuring that employees had a true stake in a venture’s success and would act and perform accordingly. As a cherry on top of the sundae, prior to June, 2005, U.S. Generally Accepted Accounting Principles (GAAP) dictated that employee stock options did not have to be charged as an expense on the income statement. This allowed for an obvious and valuable form of employee compensation with no immediate effect on the bottom line. Even further, when options are actually exercised, the profit seen by the employee is not actually paid by the company, but by the company’s stockholders, who see their already-held shares become slightly diluted each time additional options are exercised.

After the dot-come boom, of course, came a bursting of the bubble that sent many dispirited employees packing with a pink slip in hand and worthless options weighing heavily on their minds. In the aftermath of the bust, candidates were often loath to even discuss stock options, instead demanding their compensation in the form of a good, old-fashioned salary. Employers who understood and foresaw such demands quietly acquiesced and the use of employee stock options among start-ups took a hit in the late 1990s and earlier part of the current decade. This is not to suggest that employee stock options were abandoned altogether, of course, and higher-level executives were and still are almost required to have an equity stake in their companies, typically through the ownership of stock options.

For entry- and mid-level employees, however, stock options are often an optional means of compensation, and the decision regarding what to do when presented with that option is quite important. Given that, a very limited overview of what options are and how they work is in order. First, note that stock options, as the name suggests, presents the holder with the “option” of purchasing a specified number of company shares at a specified price. Choosing to purchase the specified number of shares at the specified price constitutes the “exercising” of those options.

When the option exercise price is greater than the company’s actual stock price, the options are said to be “under water”, as are publicly-traded call options with the same characteristics. In such an event, the holder would not exercise the options until such time that the stock price of the company rises above that of the option exercise price. At that point, exercising the options creates an unrealized gain equal to the difference between the company’s current stock price and the exercise price.

Further stipulations of employee stock options include an expiration date and a vesting schedule. For example, the option expiration date may be 5 years after the grant, meaning that options not exercised by that time would expire worthless. The vesting schedule, meanwhile, indicates the number of options accrued over a given period of time. For instance, an employee may receive 1,000 options (the right to purchase 1,000 shares at a given price) upon the one-year anniversary of being employed. Thereafter, he would receive 1,000 more options each year for a period of two more years (for example). In this instance, the employee will have accrued 3,000 options at the end of three years employment, and would have the right to exercise those options at any point up until the option expiration date.

This is a rather simple overview of employee stock options, but there are other details of which the option owner should be both aware and wary. Executives will often consider option vesting schedules when implementing layoffs. Put bluntly, employees are very often laid off or “downsized” almost immediately prior to becoming further vested in the employee stock option program. This financial management strategy may appear quite crass, but it is merely the reality of the situation and should be understood when considering an employee stock option program.

Also worth noting is the expiration date of the granted options. In the previous example, the expiration date of the options was 5 years from the initial grant. It is likely, however, that the expiration clause of an employee stock option contract will have further stipulations. Primary among these is that the employee’s options expire within a very short period of time upon the termination of the option holder’s employment. In short, if you’re fired, quit or are laid off, your options may expire in a few weeks or may expire upon your termination.

Last but not least on the list of things to be aware of with employee stock options is the lack of liquidity of privately-held companies. Publicly-traded firms, for example, have a very liquid equity market and the actual stock price of the company can be easily attained by glancing at a newspaper page or an online quote. Private companies, however, distribute financial information less frequently, with less certainty and with less disclosure than that of their public counterparts.

As such, a private company’s value will often be ascertained by one of the company’s own financial executives or by an outside consultant. Because there is such a non-liquid market for shares of privately-held companies, such firms will often include a “buy back” clause for those exercising options, meaning that the company itself will act as buyer of its own shares to make a liquid market. In the event that a privately-held company does not make such an offer, the option holder must exercise options at the exercise price and hold onto essentially non-liquid equity until such time that a market can be made for the shares or the company as a whole is acquired. In any event, employee stock options from privately-held companies can be a bit trickier to deal with than those of public firms, but ultimately function in much the same way and offer the option holder the same equity ownership possibilities.

Because every stock option scenario is different, it is recommended that the company is extensively researched before accepting stock options as a significant portion of any compensation package. An accountant or a financial professional is a good place to start your due diligence.

Tags: compensation, dot com boom, gaap, irrational exuberance, stock options, under water options

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