Lesson 1: Option Basics

What Are Employee Stock Options?

An Employee Stock Option (we'll simply call them options in these lessons) is the right your company gives you to buy stock at a predetermined price. You are not obligated to buy the stock, you have an "option" to purchase it. This right is ususally given or "granted" to you by means of a written agreement (often referred to as a Grant Agreement, Stock Option Agreement, etc.). Normally, this right isn't effective immediately, but becomes effective or "vests" at a specified rate over time. This right also must be used within a specified time period or it is lost ("expires").

Other Kinds of Options

Although we will refer to Employee Stock Options simply as "options" in these lessons, there are other kinds of "options." Most often, "options" or "stock options" refers to publicly traded stock options. These are options that investors buy and sell which give the owner or holder of the option the right to buy or sell stock at a set price within a specified time period. If you did an internet search on "stock options," most of the sites your search would come up with are dealing with these publicly traded stock options. Unlike your employee stock options, publicly traded options can be freely bought and sold ("traded") and a well established "public" market exists for these options (they can often be bought and sold on the major stock exchanges).

How Do Options Work?

Once your options vest (become effective), you can use or "exercise" your right to buy shares of your company's stock at the price specified in your agreement ("exercise price" or "exercise cost"). You pay the exercise cost to your company and they give you the stock. You can keep the stock or sell it (unless it is restricted stock or your are restricted by law from selling it). You will have to pay taxes of some sort on the difference between the market value of the stock you receive and the exercise cost you pay. We'll discuss the basics of how you're taxed in Lesson 2: Income Taxes.

Types of Options

There are two basic types of options:

• Incentive Stock Options (ISOs) are options that are granted special tax treatment because they meet certain requirements specified in the Internal Revenue Code (tax law). If you meet the requirements, the taxes you pay with ISOs can be significantly lower. ISOs are also referred to as Qualified or Tax Qualified Options.
• Non-qualified Stock Options (NQSOs or NSOs) are all options that aren't ISOs.
  

The Grant or Stock Option Agreement

Your company probably has a Stock Option Plan that describes the general rules applicable to all options granted under the plan. However, the actual agreement creating your options is specific to you. Unlike most other employee benefits, option agreements are not standardized. Agreements vary from company to company, from employee to employee within the same company, and may vary from grant to grant made to the same employee. You must read your option agreement carefully and you cannot assume it is the same as your co-worker's or the one your received last year! Your option agreement will specify:

• The number of shares you have the option to purchase
• The exercise price or cost
• The vesting schedule
• The term of the agreement
• Other terms and conditions
  

Exercise Price or Cost

Also called the "strike" price, this is the price at which you can exercise your options. In most cases this is a specific price per share of stock and is clearly stated in your agreement. Sometimes, the exercise price is performance based and determined by a formula.

Vesting Schedule

You can only exercise options which have met the time requirement to become effective or "vest." Although some options vest immediately, most vest on a set schedule specified in the agreement. For example, your options may vest at a rate of 25% per year, meaning that you could exercise 25% of your options after one year, 50% after two years, etc. While most agreements call for annual vesting, many vest in monthly or quarterly increments. You must refer to your agreement to determine what your vesting schedule is.

The Term of Your Options

Every grant has a start date and a termination or expiration date. Typically, this is a period of ten years, but it can be any time period. If you don't exercise your options before the termination date, they will "expire" and you will loose them. Knowing and keeping track of your termination date is extremely important!

Your options may also terminate if you leave employment at your company for any reason or if your company is merged into or acquired by another company. Read your agreement carefully to find out what happens in these circumstances.

Transferability

While most options cannot be transferred, some agreements allow for certain transfers, primarily to family members or trusts, for estate planning purposes.

Other Key Terms and Conditions

Because option agreements are not standardized, there are all kinds of terms and conditions that may be specified in your agreement. We cannot stress enough how important it is for you to read you option agreement carefully!

Exercising Your Options

The procedure for exercising options varies from company to company, so the first step is to contact your Human Resources department or whoever is responsible for administering your option program. Generally, you will be required to complete certain forms, either pay or arrange for payment of the exercise cost and any taxes due on exercise, and then you receive the stock.

Unless your options are ISOs, you will need to pay both the exercise cost and the taxes that the company is required to withhold. The simplest way to do this is to write a check to your company. Often, this amount will be substantial and you may not want to or be able to pay it from your funds. So options are often exercised by having a brokerage company lend you the money needed and then immediately sell enough shares of the stock you receive to repay the loan. This is what's called a "cashless" exercise. If you already own shares of your company's stock and your agreement allows for it, you may also use that stock to "pay" these exercise costs in what's referred to as an "exchange." Exchanges have tax ramifications which should be fully understood.

Finally: Holding or Selling The Stock

Once you exercise your options, you receive the stock. Usually this means that the stock is held in a brokerage account for you. You can keep the stock by allowing it to remain in that account, having it transferred to another account or by asking to have the actual certificates distributed to you. If you keep the stock in a brokerage account, when you are ready to sell it, all you have to do is instruct the broker to sell the stock for you. (If you are holding the certificates yourself, you will have to deposit them into a brokerage account and then instruct the broker to sell the stock.)

Generally, you can sell the stock anytime you want to unless:

• The stock you receive is restricted stock. This usually happens when you exercise your options before or shortly after your company's stock becomes publicly traded (an initial public offering or IPO). In such cases, you want to discuss these restrictions with your plan administrator and/or the broker and make sure you understand when these restrictions will be lifted and you are free to sell the stock.
• You are restricted from selling the stock. If you are considered an "insider" by securities law, there are times when you will not be able sell the stock. If you do not know, ask your plan administrator or corporate counsel if you are subject to these restrictions.
• Your company's stock is not publicly traded. If you work for a privately held company, meaning that the share of your company's stock are not registered for sale and traded on any of the public stock exchanges, you may not be able to sell your stock. In this case, you will need to talk to your company's management regarding when and how the stock can be sold.

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