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Stock Options

By Bruce Gottlieb

Learn the basics about stock as a form of compensation.

While stock options can make you rich quick, you've got to watch out for the fine print.

A recent New Yorker cartoon features a cheeky young man begging for change on the corner. He's sporting a well-cut suit, an ear-to-ear grin, and a sandwich board that reads, "Exercised my stock options but am unable to access my wealth for another six months." The cartoon's message is rapidly becoming a cliche while stock options can make you rich quick, you've got to watch out for the fine print.

Options may not have made millionaires out of you and me, but they are an increasingly common--and desirable--form of compensation that companies use to lure talented employees. Therefore, it makes sense for job-seekers, especially those in high tech industries, to know how they work.

A stock option is nothing more than the right to buy stock in a company at a specified price, known as the "strike price." The strike price stays fixed no matter what happens to the stock's actual value. Let's take an example. Suppose you are offered a job at a fictional high tech firm called DigiTech. In addition to a salary, health insurance, and a pension plan, your compensation package might include, say, 40,000 options with a strike price of $30 (meaning that you can buy as many as 40,000 shares of DigiTech at $30 per share).

If DigiTech shares are trading for less than $30, then your options are worthless, at least until the price goes up. Unless the market price is higher than the strike price, it doesn't make sense to "exercise" your options, or convert them into shares. If the market price never climbs above the strike price, economists would say that your options "finished out of the money."

But if DigiTech stock rockets up to, say, $130, then your options are very much "in the money." You can buy shares for $30 and immediately sell them on the stock market for $130--a riskless profit of $100 per share. Your 40,000 options are now worth $4 million.

The ultimate value of your stock options depends on three things: (1) the number of stock options you have, (2) your strike price, and (3) the stock market price of your employer's shares when you exercise your options. Let's look at these three variables in turn.

Some companies offer the same number of options to all employees. But the number of options you receive may also depend upon how badly they want to hire you. You may be able to negotiate a higher salary with fewer options or a lower salary with more options. It all depends upon your appetite for risk--more options means more risk, but with an increased chance of a huge payoff.

Your strike price is usually the lowest price at which shares have traded within one month of your hiring. In other words, you benefit from any rise in the stock price from the moment you begin work. Many smaller companies like to pay employees in stock options for precisely this reason--they provide an incentive to work hard. A second reason for using stock options is that they allow the company to borrow against the future. They don't have to pay increased salaries today if they give away stock options that will be exercised only in the future, when the company has grown--or gone bankrupt.

It's important to be realistic about the chance that your company will turn into the next Microsoft or It is true that rapidly appreciating stock options will make you rich. But if you really possessed a clairvoyant sense for picking stock market winners, you could just call a stockbroker, buy stock in those companies, and never have to work in the first place. In other words, it's important to think about best- and worst-case scenarios when estimating the value of a compensation package that involves stock options.

In sum, the best way to think about stock options is to consider them icing on the cake. They ensure that you'll be handsomely rewarded if your company makes it big. But it's dangerous to pick an industry or a firm on the assumption that stock options alone will make you rich.

Finally, there is one further caveat with stock options. Even if the stock price rises early on in your tenure, you will probably have to stay with the firm for at least four years to take full advantage of your options. This is because most firms do not allow you to exercise your options right away. Typically, you may only exercise a quarter of your options for each year that you've been with a firm. For instance, if you received 40,000 shares initially, then you will be permitted to cash out only 10,000 options after one year with the company. After two years you can access an additional 10,000 options, and so on. Only after four years will you be able to cash out the full 40,000 options. This is called the "vesting" process--every year one quarter of your options become vested, meaning that you are able to cash them in.

It's also customary for companies to give additional options to valued employees at bonus time, but generally, you may only exercise these options according to the four-year vesting schedule described above. That is, suppose you are given an additional 10,000 options as a bonus during your second year with DigiTech. You may not be able to cash out these options until your sixth year with the company.

If you leave before becoming fully vested, then you simply lose any unvested options. So in our DigiTech example, leaving after two years means forfeiting 20,000 options, which can represent a lot of money if the company is successful. This is why stock options are often referred to as "golden handcuffs"--they often make it financially insane for an employee to leave even if he or she would otherwise prefer to take another job. This is not necessarily an argument against taking stock options, but it's something that you should know going in. And don't forget to read the fine print.

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