Stock Options For Dummies

Alan R. Simon

• Publisher: For Dummies
• Year: 2010
• ISBN:
  9781118053775
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Confused by all the brouhaha surrounding stock options? Let expert Alan Simon demystify this often-confusing investment vehicle for you. If you're like the majority of the estimated 12 million employees in the U.S. who have stock options as a key component to their compensation packages, you have a vague notion, at best, of how options work and what they can mean to your financial well being. What's the vesting schedule for your shares and how will their strike price be set? What type of stock option grant will you receive, an ISO (incentive stock option) or an NQSO (non-qualified stock option)? What tax rules apply to your option program? Your financial future could depend on your knowing the answers to these and other questions regarding your company's stock option plan.

Featuring clear explanations of how your stock options might make you money—or not—this friendly guide fills you in on what you need to know to:

• Understand different types of stock options
• Read and find traps in your stock option agreement
• Evaluate the pros and cons of company investment vehicles
• Assess vesting schedules and tax laws
• Tap Web resources

Simon demystifies the jargon, rules, and tax consequences of stock options. He provides a realistic picture of what to expect from your options, and he helps you see past the hype to understand what your employer is really offering. Important topics covered include:

• What you need to know before accepting a compensation package that includes options
• Developing a stock option philosophy and clear-cut goals
• Knowing whether you're being treated fairly by your company
• Making sense of the language of stock options agreements
• Getting a handle on key restrictions on how you exercise your options
• Stock option valuation
• Tax rules and how they apply to different types of options
• How stock options can be affected by changes at your company

Stock Options For Dummies is the only guide you'll need to get the most out of this important investment vehicle.

Part I

The Fundmentals of Stock Options

In this part . . .

This part explains the basics of stock options: how they work, how you might make a lot of money, and — sorry to say — how your stock options might turn out to be little more than a “wouldn’t it have been nice” fantasy. You’ll see how to match different types of employment situations and stock option packages to your own circumstances and tolerance for risk to help maximize your chances for stock option profits. You’ll also get a look at the types of stock option packages the “big guys” in your company — like the CEO and the Board of Directors — have.

Chapter 1

Stock Options: What You Need to Know Right Off the Bat

In This Chapter

Knowing the basics of stock options

Figuring out why companies give employees stock options

Knowing what happens when you receive stock options

Understanding the two main kinds of stock options

How’s this for a new show hosted by Regis Philbin: “Who Wants to Be a Stock Options Millionaire?”

Forget about athletes, actors, and musicians. Throughout the 1990s, the world watched entrepreneurs like Bill Gates (co-founder of Microsoft) and Larry Ellison (founder of Oracle) become billionaires, largely because of their holdings in the companies they founded. Many people were even more enthralled by the legions of plain old regular employees like the “Dellionaires” — workers at Dell Computer who became millionaires from the spectacular rise in their company’s stock throughout the decade — whose good fortunes convinced so many others that employment-driven wealth was just around the corner and achievable by almost everyone!

Just because you go to work for a company that gives you stock options doesn’t mean you’ll automatically become wealthy — but it might happen. This chapter explains how stock options work, why your employer might give you stock options, and how you might profit from those options.

Understanding Stock Option Basics

Stock options are actually very complex: You’ll face many challenges ranging from managing your personal financial portfolio, to taxes, to trying to determine whether or not you should remain at a company where you hold stock options. Don’t worry. I address all of these issues in subsequent chapters throughout this book and make the whole process a lot less intimidating. For now, however, just concentrate on understanding the most basic aspects of stock options, as I discuss in this section.

Knowing what stock options are

A stock option is the right to purchase a specified number of shares of a company’s stock at some point in the future at a contractually specified price — rather than whatever the stock price will be on that future date. And, if the fates smile upon you, that contractually specified price will be lower — hopefully much lower — than the market price for the stock on that future date, meaning instant profit for you.

For example, suppose that you begin a new job at GreatPlaceToWork.com as a software developer. In addition to your starting annual salary of $50,000, you also receive a stock option grant, which is a legal agreement between you and your employer. This particular stock option grant gives you the right to purchase 10,000 shares of GreatPlaceToWork.com stock at the price of $3 per share.

At some point in the future — say, in five years — GreatPlaceToWork.com has done fantastically well, and the stock price is $103 per share. Because of your stock option grant, you could buy 10,000 shares of GreatPlaceToWork.com stock at only $3 per share, turn right around and sell those 10,000 shares for $103 each, and make a gross pre-tax profit of $100 per share — or $1 million!

You can substitute the term employee stock options for the more generic phrase stock options for almost all of the discussion throughout this chapter and this entire book. You will almost always find yourself holding stock options as a result of being employed at a company that has a policy of issuing stock options to its employees, including you.

I will specifically note when I am referring to stock options issued to individuals who aren’t actually employees of a company. For example, Chapter 4 discusses stock options owned by investors and members of your employer’s Board of Directors — people who may not actually be employees, even though they are associated with your company. And in Chapter 19, I’ll discuss the now-passé phenomenon of using stock options as a form of currency in exchange for advertising services, consulting work, or leasing office space. For the most part, stock options held by non-employees work the same as employee stock options that you and your fellow workers hold. So while it’s safe to think of the terms employee stock options and stock options as interchangeable, I’ll explicitly call your attention to any differences.

Other types of stock options

Stock options issued to employees, Board of Director members, and others with some sort of relationship to a company are not the same as publicly traded stock options, which you may have heard about or have had some experience with. You can find publicly traded stock options along with the stock price listings in The Wall Street Journal or the financial pages of a major newspaper like The New York Times.

There are two types of publicly traded stock options:

Call options (or calls) allow the holder to purchase shares of stock at a predetermined price, even if the current market price of the stock is higher than that predetermined price.

Put options (or puts) allow the holder to sell (rather than buy) shares of stock at a predetermined price, even if that price is higher than the current market price of a stock.

Call options work much the same way as employee-oriented stock options, with one major distinction between the two. Calls — like puts — are publicly traded, meaning that anyone can buy or sell them. In contrast, employee-oriented stock options are usually not marketable, meaning that you’re contractually forbidden from selling your stock options to someone, nor can you purchase someone else’s stock options.

Calls and puts are a complex enough subject, so all you need to remember is that the types of stock options we discuss in this book are not the same as publicly traded stock options. So when you hear phrases such as “covered calls,” “straddles,” and “naked puts” (don’t ask!) in reference to stock options, then it’s the publicly traded stock options — not the subject of this book — that someone is talking about.

Knowing how stock options work

This section discusses the basics of how stock options work and what happens when you receive stock options.

As we previously mentioned, when your employer gives you stock options, you formally receive a legal document called a stock option grant. The stock option grant contains several very important details about the stock options, including:

The strike price. The price at which you can purchase shares is known as the strike price of your options. No matter how high your company’s stock price goes from that day forward, you will always be guaranteed the right to purchase shares of stock at the strike price specified in your stock option grant. (In the GreatPlaceToWork.com example earlier in this chapter, the strike price specified in the stock option grant is $3 per share.) Sometimes, a stock option grant will use more generic language such as option price or exercise price, but the street slang is “strike price.” Note that in your stock option agreements, you’ll usually find the term option price or exercise price rather than strike price, but in job offer letters and informal communication with a prospective employer, you’ll more commonly see the strike price term used.

Number of shares. Sure, it would be great if you could turn around and say, “Ok, I want to purchase 1 million shares — no, ...