Employee stock options or equity grants allow employees to buy the business stock at a predetermined price later (after the vesting period expires). The employee can purchase the shares at the end of the vesting (lock-in) term, exercising the stock options.
Stock options are issued at an exercise price lower than the stock’s Fair Market Value (FMV), which is the stock price when publicly traded on the open market.
The fair market value of a public company is open to the public and established by the market. The FMV of a share of common stock in a private corporation is the acknowledged current value of that share. Independent third-party appraisers assess fair market value. It represents the value of the stock on the open market.
If the stock price rises, the employee will profit if the option is exercised at the strike price that is lower than the current stock price or FMV. If the stock loses value, the option will be worthless, and the employee will not exercise the option and hence suffers no loss.
What is Strike Price?
Stock options provide the option holder the right to purchase a certain number of company shares at a specific price, known as the strike price, grant price, or exercise price.
The stock options strike price equals the fair market value (FMV) of the company’s stock on the day the option is granted.
Private companies usually use an independent 409A valuation provider to evaluate the fair market value of their common shares. This can help them avoid expensive audits and their employees from penalties.
If the options are not vested, the company will not allow employees to exercise the options until a specific amount of time has passed.
This is essentially a technique of retaining employees at the company for a longer time and motivating them to work for its long-term success because they will directly profit if the stock price rises after the vesting period.
An employer and employee agree on stock options terms on the grant date. The stock options become vested when an employee meets the requirements or has passed the relevant time.
Hence, the options can now be exercised or purchased by the employee. Within that time frame, the employee is given a specified amount of time to exercise their options. Just as employees cannot exercise options before they vest, they cannot exercise them after they expire.
How do Stock Options Gain Value?
The strike price plays a vital role in deciding the premium paid for an options contract:
At-the-Money stock options
When the strike price of an option is the same as the FMV or current stock price, it is known as at-the-money. For example, if the XYZ stock is trading at $75, and the option’s strike price is also $75, then the options are considered ATM since the strike price of the option is equal to the FMV of the stock.
ITM implies that an option has a lower strike price than the current market price or FMV of stock.
When the FMV of the stock increases, the difference between the FMV and the option strike price is called the spread. This is the underlying value of the stock. When the spread is positive, options are considered ITM.
If the XYZ stock is trading at $75, and the option’s strike price is $65, then the options are considered ITM since the strike price of the option is less than the FMV of the stock.
Then by exercising the options, employees can purchase the shares at $65 and immediately sell them for the current market price or FMV of $75 and earn a per-share profit of $15 (minus applicable fees, taxes, and expenses)
Underwater stock options
In the case of underwater stock options, the strike price will be higher than the stock’s FMV.
If the XYZ stock is trading at $55, and the option’s strike price is $75, then the options are considered underwater since the strike price of the option is much higher than the FMV of the stock.
For obvious reasons, the option holder would not want to exercise underwater stock options:
- The option holder pays more for the shares than the current market price.
- The exercise will result in no tax savings that the option holder can offset with other income.
Hence, the employee will not exercise their option and will not suffer any loss. That is, if the stock declines in value, the option will be worthless, and the employee will not suffer a notional loss as with typical stock ownership.
The Bottom Line
The value of the options depends on strike price, stock value (FMV), and the economic value of the options (spread between the FMV and strike price of the option).
When a company offers stock options, the goal of an option holder is to buy them at a price lower than the FMV of the stock and sell them to make a profit. After the employee has exercised the option, they can sell their shares at any time or after the company’s stipulated lock-in period expires.
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