What are stock options?

Stock options are available for purchase at a price known as a premium for your employees, investors, and other interested parties. It earns them the right but not the commitment to purchase or sell stocks at a set price within a given timeframe. The seller of the stock option is known as the option writer, and they are paid premiums from the contract purchased by the buyer.

As a startup owner, leader, or investor, it’s important to understand this crucial concept, as it affects your company's future growth and financial decisions. 

Read on to learn more!

Stock options meaning

Stock options give your investors the right to buy or sell your startup's stocks at a given time and price. Since the stock index serves as the underlying asset for stock options, they become a type of equity imitative, explaining why they are also known as equity options. 

As a startup founder or leader, you can issue your employees with employee stock options (ESOs), which can also be termed as call options. ESOs are a form of equity compensation that your company can give to executives and other selected employees. However, ESOs differ from listed options on stocks trading in the market as they are designed for a given corporation to its employees.

What is the purpose of stock options?

Stock options are a popular technique for attracting potential employees and retaining existing ones. Since company stocks are available at a discounted rate, it’s easier for your company to attract incredible employees in need of affordable stock options and retain them.

Retention of employees with stock options occurs through vesting. The latter enables you to motivate your employees to stay through the vesting period by taking ownership of the available options. However, your employees must meet the requirements of the vesting schedule – only then can they own the options.

For example, you can issue 10,000 shares with a four-year vesting schedule of 2,500 shares at the end of every year. In such cases, the employee must stay for at least one full year to exercise the first 2,500 options and four years to exercise all 10,000. The employee must remain with your company for the entire vesting period to receive their full grant.

Stock option types

Stock options come in two primary types:

• Call option: It grants the buyer the right – not the obligation – to purchase your company's stock. It increases in value every time the company stock price increases. It is a bet that the stock price will increase over time.
• Put option: It grants the buyer the right to sell off stock short. It increases in value when the organizational stock prices drop – a bet that the stock price will fall.

An investment banker can purchase both stock options types – independently or together – to practice covered calls among other relevant trading techniques.

How do stock options work?

As a startup founder, you can issue stock options at prices known as premiums. Doing so means you sell off the rights associated with the option – the investor gets the right to buy or sell stocks at a price and time frame you set. Stock options include an expiration date, and the buyer must use the options before the specified date.

This means the buyer becomes the owner of the option until the expiration date. Alternatively, the buyer can exercise the option – buying or selling the underlying stock associated with the option. 

Besides the expiration date, the stock option contract features a strike price. The latter refers to the specific set price, which can be higher or lower than the actual stock price. If the strike price is $50, but the actual stock price is worth $60, the buyer makes a $10 profit by paying $50 for something they would have bought at $60.

What are employee stock options?

An employee stock option plan (ESOP) is a form of equity you can use to give your employees partial ownership of your company. As your startup's partial owners, your employees are motivated to work towards organizational success, thus increasing returns through stock option returns.

Some companies grant their employees ESOPs without upfront costs, while others offer more shares for employees who stay longer in the company. However, cashing in on an ESOP can be challenging, depending on the contract. While some plans only allow employees to cash out their ESOP profits on retirement, others allow employees to take their earnings and the cost of their shares when leaving the company.

What are the uses of stock options?

• As a startup founder or leader, you can enjoy various uses of stocks in general. For instance, you can raise your company's capital by issuing stocks to the public. 
• Individuals who buy stocks, your employees, and other investors can reap higher returns by investing in stock options. 
• Most careers in finance, such as investment banking, involve buying and selling stocks/ stock options. As an investment banker, you can use stock options to incentivize investors to support a startup going through an initial public offering, IPO. The possibility of making huge profits from low strike prices may encourage investors to buy more stock options than they initially would.
• Hedge funds and private equity firms can use stocks and stock options to raise capital from investors. 

Any company, including your startup, can offer stock options to create more capital – for growth and expansion – and attract and retain competent employees using ESOPs.

Stock option parameters

Some of the major stock options parameters include the following:

Strike price

The strike price refers to the pre-set price of your company's stock options. It is the price that the buyer expects the stock options to be above or below by the expiration date, and it determines whether an option should be exercised.

Expiration date

Stock options are contractual; they exist within a specified period. An expiration date refers to the date by which the stock options buyer should have exercised the options. The dates are set according to a fixed schedule – options cycle – which ranges from daily to weekly, monthly to yearly. Options with longer expiration rates have a greater time value as the option has a greater chance to grow as the underlying stock moves around longer.

There are two major expiration and settlement styles in the market:

• American style – It allows the option holder to exercise their option any time between the purchase and expiration date
• European style – The option holder can only exercise the option on the expiration date. It is less popular than the American style.

In the past, stock option settlement transactions were proven by certificates. Today, the settlements are done in cash, depending on the underlying stock's value.

Contract size

A contract size represents the specific number of underlying shares an investor may want to buy.

Premium

A premium refers to the price the buyer pays for a stock option. You can determine the premium by multiplying the call's price by the number of contracts bought, then by 100. The volatility of the underlying security is a crucial concept in pricing. Greater volatility translates to higher premiums on the options listed on the given security. 

Stock options: Key takeaways

Understanding what stock options are and how they work is crucial for you as a startup founder or leader. Issuing these options, for instance, can help you motivate competent employees to stay longer in the company and attract the best prospects. 

Besides, the options allow you to plan properly as you know when the employees are likely to sign the grant, exercise the options and leave the company. Ultimately, you will make an informed decision regarding the company's future.

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Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.