Stock Options Employee Benefit: The What, Why and How
Stock options as employee benefits had been a staple of compensation packages in the USA and European Union for quite some time. However, it is still a new type of offering in the Ukrainian IT segment. As such, it makes sense to explain what it really means.
When it comes to employee benefits – it all comes down to building a compensation package that can withstand competition. That ‘s where SO stands in the grand
This article kicks off a series of pieces related to stock options. In this episode, we will sort things out regarding stock options as employee benefits, explain how it works, and why it matters.
What are stock options?
In the IT context, the stock option is a type of employee benefit the company can provide in the compensation package.
Traditionally for the IT industry, stock options are very popular with startups due to limited initial financing. However, it is a common thing among the product companies too, usually for the executive-level management.
- In a nutshell, stock options as an employee benefit is a workaround for the scenario in which an employee comes in on a lower than average salary with a stock option as a possibility of a big payoff later down the line.
So what are stock options?
- In general terms, stock options are investment tools.
- Options are not stock. Stock is the actual part of the ownership of the property. It is broken down into shares – the smallest denomination of said property.
- The stock option enables the owner to buy\sell company stock at a specific time and a pre-set grant price. The owner of the stock option can do that, but he is not obligated to do so.
- Stock options don’t have any real value as they are. It is an agreement first and foremost.
- Pre-set grant price means the fair market value at the moment of granting a stock option.
- The number of stock options depends on multiple factors. In the context of IT, the most common differentiation is by position seniority and\or employee impact.
The pitch is that the stock price will eventually go up, and the stock owner would strike gold.
But there’s a catch.
- Stock options have predetermined expiration dates, after which the owner can’t exercise them. The timeline is set by the ones who grant stock options.
- Additionally, some companies require employees to exercise their stock options in a time window after leaving the company.
Stock Options as Employee Benefits Explained?
There are two main reasons why stock options are viable employee benefits in the IT industry.
- Stock option as a tool to attract and retain talent.
The competition for tech talent is tough and fierce. When it comes to giving an additional reason to choose a particular company and stay along the ride – the chance to own a part of it is quite a treat.
- Maintaining Employee Motivation and perpetuating Employee Dedication.
As an extension of the previous point, stock options work well as a driving force to commit to the company’s eventual success. If the company does well, you can buy a stock that will cost a fortune.
But why should employees care?
- Buying stock is expensive if you are not a professional investor and don’t follow the market trends. Even if you do – buying stock is still a hefty investment because you want to buy something valuable that will multiply its value and benefit you.
- You can influence the events. As a company employee, your work directly impacts the value of the potential stock. Every effort counts in the eventual success of the company and its growing stock price.
How do stock options work?
So, we have already talked about two integral elements of stock options – grant price and deadline. What else is there to explain?
Here’s an example:
- Mr. A accepts an offer from a fledgling startup. Amidst his compensation package are stock options. Let’s say there are over 9000 of them. What happens next?
- The company and Mr. A sign a contract that explains the terms of these specific options and document the agreement between the two parties. Usually, this contract is an extension of the regular employment contract.
The contract includes the grant date – when the options become available for purchase (or in investspeak, “begin to vest”).
- Usually, stock options become available gradually over an extended period. So – no buying stock from the get-go.
The timeline is broken down into two parts:
- The vesting period describes the timeline of stock options becoming available—for example, a three-year vesting period. By the end of year one, Mr. A will have 3000 options available.
- Cliff is a type of fail-safe to keep options from fraudulent intent. Here’s what it means – an employee needs to stay on the job for a specific period to receive any stock options. The most common is a one-year cliff.
- After reaching a one-year cliff, an employee gets his first portions of options and paves the way for the rest.
There is also an expiration date – when the stock options cease to exist.
- The contract specifies the date. Common expiration options are X years from the grant date or 90 days after leaving the company.
But what if you quit before that?
- Well, if one fails to pass the one-year cliff, then one won’t get any stock options.
How to exercise Stock Options?
Once the stock options start vesting, the owner can exercise them and buy shares of stock.
The price of the share is set in the contract. That’s the grant price, aka strike price aka exercise price. The contact sets the grant price in stone. It never changes.
Here’s an example:
- As we have mentioned earlier, Mr. A got 9000 options after three years at a $1 grant price.
- To exercise stock options, Mr. A needs to pay $9000 to use all 9000 options (or whatever the number of available stock options one wants to buy at the moment), and that’s it. Mr. A owns stock and can keep it or sell it.
- Also, one needs to pay commissions, fees, and taxes related to exercising options.
So that’s the starter’s pack on stock options, what they are, how they work, and why they are a viable employee benefit. With that said, the topic is far broader than that.
In our forthcoming articles, we are going to explore:
- The specifics of SO in Ukrainian IT;
- SO as a benefit from the employer and employee points of view;
If you need any help regarding employee benefits research or other HR-related consulting – contact us.