Stock Options Definition: All you need to know

If you own Employee Stock Options, then you must understand what they are and how they work.

In this post, we’ll cover everything from the stock options definition to the basic concepts, to the best practices on how to make your stock options work for you (and what they’re actually worth).

So…

What are stock options, really?

Stock options are your ability as an employee to purchase shares of your company at a fixed price, at a fixed future date. In other words, you can buy a piece of your company when you convert your options into shares. (“Shares” mean company’s stocks.)

It’s a simple concept, but it can be overwhelming.

Google comes up with about 208,000,000 search results when you type in “stock options definition.” This gives you an idea of how complex this concept is. Many people are thoroughly confused about it.

Stock options definition

But don’t worry.

Stock options sound complex because most articles you read on the web use financial lingo to explain them. We’ll tell you how stock options work in plain, easy to understand language.

In this post, we’ll cover:

  1. What stock options are;
  2. How stock options work;
  3. The 5 types of stock options:
        • Incentive Stock Options (or ISOs);
        • Non-Qualified Stock Options (or NSOs);
        • Restricted Stock Units (or RSUs);
        • Restricted Stock Awards (or RSAs);
        • Performance Stock Units (or PSUs);
  4. The common stock options terms:
        • Price: strike price, grant price, exercise price;
        • Vesting: vesting cliff, vesting schedule;
        • Date: vesting date, exercise date, expiration date;
  5. How to use stock options to make a profit;

Let’s dive in.

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What are Stock Options?

Stock options are really just big numbers on paper that you can convert to company shares—actual company stocks that will be worth something if your company does well (or if it continues to grow).

So, the value of your stock options is theoretical. It’s tied to both yours and your company’s performance.

But there is a catch.

First of all, you get only so many options. Meaning, the number of them is fixed. Read your Employee Stock Options Plan to see how many you’ve got.

Second, you can begin to convert them into actual shares only at a fixed future date. And there will be several of those dates that will let you convert chunks of options, but not all of them at once. This prevents you from getting a new job, getting stock options, exercising them, making money and leaving.

And third, your stock options will expire on yet another fixed future date. If you don’t convert them to shares by that date, they’ll become bits of paper with no value.

Do you see how this works?

Stock Options are a promise. It’s the company’s promise to give you a piece of it—if you stay at your job and if you do well. In turn, you’ll help the company do well, and you’ll both prosper.

But if you won’t do well, and if the company doesn’t do well, then your stock options will be worthless.

It all comes down to risk and potential reward.

Are you willing to risk big and get a big reward?

For example, if you join a pre-funded (or very early funded) startup, then your risk is high but so is your reward. If you join a mature startup or a middle-sized company, then your risk is moderate but so is your reward. Finally, if you join a large and well-established public company like Google or Facebook or Apple, then your risk is low and so is your potential reward.

You make the bet.

But if you choose to make this bet, then be smart about it:

Now, let’s drill into details on how stock options work.

SIDENOTE: GrowthAdvisor is the only service that calculates and predicts the cash value of your Employee Stock Options.

How Stock Options Work?

Because stock options are nothing more than a promise of a future gain, companies got creative at making them shiny and attractive to potential employees. After all, why would you work for a promise that’s worth nothing?

Think of stock options as a carrot that hangs within reach. The better your work (and the longer you stay at the same company), the closer you get to reach the carrot.

Of course, you know that at any moment your company can go belly-up, and that carrot will vanish. But you also know that at any moment your company can skyrocket to success, and that carrot will turn to gold—solid gold in your hands.

It’s a risky business, yet it’s also exciting. Like a game. Will you lose? Will you win?

You don’t know for sure, so…

To motivate you to keep reaching for the carrot, companies created many types of stock options and many types of restrictions that have to be met for you to get the carrot (especially if it turns to gold). Plus, different types of stock options could be given to different types of employees—from co-founders to the first employees, to directors, to senior managers, and to new hires who join the company as it matures.

But don’t let the complicated terms intimidate you. At its core, all stock options types are the same. They promise to give you equity (a piece of the company) in exchange for your loyalty and your performance.

The three basic things you need to know about your stock options are:

  1. The number of your options;
  2. The price of your options;
  3. The valuation of your company;

But before we get to this, let’s take a quick look at the five types of stock options

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The 5 Types of Stock Options

All stock options can be categorized as types of company equity.

This company equity differs in when and how much money you can make from it (and under what restrictions) and how that money will be taxed. In other words…

It all comes down to the amount of money you’ll make, plus the amount of time it’ll take you to make that money.

Let’s take a look at the five most common stock options types today. New types can crop up any time, so be sure to bookmark this post and return later for updates. (There are more than five types—read about them here).

  1. Incentive Stock Options (ISOs);
  2. Non-Qualified Stock Options (NSOs);
  3. Restricted Stock Units (RSUs);
  4. Restricted Stock Awards (RSAs);
  5. Performance Share Units (PSUs);

What are Incentive Stock Options (ISOs)?

Incentive Stock Options are the plain vanilla of stock options. That’s the type you probably got. They’re regular options awarded to many new hires. The money you make on them is taxed as a capital gain. So you pay less in taxes.

Read more about ISOs here.

What Are Non-Qualified Stock Options (NSOs)?

Non-Qualified Stock Options differ from Incentive Stock Options in that the money you make on them is taxed as regular income. So you pay more in taxes. Otherwise, they’re pretty much the same.

Read more about NSOs here.

What are Restricted Stock Units (RSUs)?

Restricted Stock Units get their value assigned to them not when you get them, but when they vest. Also, they’re the promise of a promise. Meaning, RSUs are the company’s promise to give you stocks in the future—if certain restrictions are met.

Read more about RSUs here.

What are Restricted Stock Awards (RSAs)?

Restricted Stock Awards are similar to RSUs, but because they’re awarded to you, you get them immediately. No need to wait for certain restrictions to be met like with RSUs.

Read more about RSAs here.

What are Performance Stock Units (PSUs)?

Performance Stock Units are almost a clone of RSUs, but you get them only if you meet a certain performance goal. Hence, Performance Stock Units.

Read more about PSUs here.

Oof. That was a lot to cover, wasn’t it?

Do you see how there isn’t that much difference between all of them?

The concept is the same. You own a piece of the company as a perk on top of your salary. And this perk can turn into serious money.

Now, let’s talk about common stock options terms that can show you how you can make your stock options work for you (and turn a good profit).

The Common Stock Options Terms

If you take time to read your Employee Stock Options Plan (not many people do—so you’re already ahead of the pack!), you’ll see terms like “strike price” and “vesting schedule” and “expiration date.”

They’re common, everyday ideas hiding behind financial lingo that might first throw you for a loop.

Let’s simplify them to what they really are.

Price:

You probably came across terms like Strike Price and others. Well, a Strike Price is the same as the Grant Price. It’s the price of your stock options when you get them the first time.

Now, the Exercise Price is the price at which you exercise your stock options. It differs in when you do it, but it’s the same price at which you got your stock options (even if you exercise them four years later). So again, it’s all the same. Simply the price of your stock options.

But…

There is another price you need to keep track of. The Market Price. This is the price of your company’s shares. When you exercise your stock options and buy shares, the difference between the price you paid for the shares (Strike Price) and the price the shares sell on the market (Market Price) is your profit.

Vesting:

The word “vesting” means ripening or maturing. Think about your stock options as unripe and sour apples hanging on a tree. When the apples turn sweet and delicious and are ready to be picked, they “vest.”

There are two terms you’re likely to come across: Vesting Cliff (or Cliff Vesting) and Vesting Schedule.

A Vesting Schedule is a set of fixed future dates at which you get fixed amounts of stock options. The interval at which you get a new chunk of options is usually one year. And the total waiting time until you get your last piece of options is 4-5 years.

This means that if you got 2,000 options, then after 1 year you get 500 options and can exercise them right away. In another year you’ll get another 500 options, and so on. Pretty simple.

A Vesting Cliff is the beginning of the Vesting Schedule. Usually, it’s the first year you have to stay at your job—before you can exercise a chunk of your stock options.

For example, let’s say you have 2,000 shares in a 4-year quarterly Vesting Schedule with a 1-year Vesting Cliff. That’s 500 shares per year or 125 shares per quarter. BUT! For the first year, you get nothing. Then at the 1-year anniversary of the grant (the Vesting Cliff), you get 500 shares, then 125 more every quarter thereafter.

Read more about vesting here.

Date:

The various dates you need to know about are:

  • The Vesting Dates (when you can get a new piece of your stock options);
  • The Exercise Date (when you can exercise your stock options—the moment they are vested);
  • The Expiration Date (when your stock options expire);

There isn’t anything complex about them.

You’ll see your Vesting Dates in your Vesting Schedule. Simple.

And you’ll see your Exercise Date in your Employee Stock Options Plan. This is the date on which you can convert your options into actual shares.

The Expiration Date is the one you’ve got to note. This is the date when your stock options expire. And with them, your right to purchase company shares at the Strike Price expires as well. So if you miss this date, you’re left with nothing.

Want to learn even more? Read this guide to employee equity by YCombinator.

Now let’s take a look at how to profit from your Employee Stock Options.

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How to use stock options to make a profit

As mentioned before, the three most important things you need to know are:

  1. The number of your stock options;
  2. The price of your stock options;
  3. The valuation of your company, and the percentage that you can potentially own;

Why do you need to know this? Because your stock options represent real money.

Think again about the stock options definition. You have the right to own a piece of your company. But how large is that piece? How much money would you need to buy it? And how much money will you make if you buy it, then turn around and sell it?

Most important of all, when do you sell it? Will it make you the most profit to sell when your options vest? Or will you profit more if you wait?

Don’t let these questions confuse you.

That’s what we do at GrowthAdvisor. When you sign up, we ask you simple questions and do the calculations for you.

It all comes down to the value of the company and the difference between the Strike Price and the Market Price.

The problem is, all three fluctuate and are hard to predict.

At GrowthAdvisor we have developed a unique and sophisticated algorithm that analyzes companies’ past performance patterns and predicts all of the above and then some.

Here, try it for yourself. It’s free.

Understanding the math of stock options is good practice. If you know your numbers, you’ll know how to make a profit. If you don’t know your numbers, you won’t know how to make a profit. It’s as simple as that.

Whichever way you decide to go—learn the stock options math on your own or let GrowthAdvisor help you—you’re already doing more than many employees.

Yes, the whole business of stock options may seem complex at first, so it’s easy to get confused.

Our advice is simple. Focus on the basics.

Get started with what you know now. You’ll learn more over time.

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Final note

Understanding how stock options work is the foundation of your success in making a profit.

Stock options can add a nice chunk of cash to your salary. In some cases, they can double your earnings. And in some very lucky cases, they can make you a millionaire.

Ready to give it a try?

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