How Do Stock Options Work

There are thousands of financial terms out there, most of which rarely enter the lexicon of investors, aside of course from the most specialized and dedicated in the industry. From a ‘call’ to a ‘stock put’ and every other term in between, the incredible range of financial terminology creates a major issue for newbies to the industry – it confuses them, potentially alienating from investment success.

However, as difficult and vast as financial terminology can seem, the vast majority of heavily-used financial terms are few and fairly simple. Stock traders and brokers alike need only know a fraction of the industry’s overall vocabulary and terminology. Those in the forex and commodities world are in similar situations, needing to understand only a small slither of the industry to find success.

Today, we’re going to look at a stock term that’s rarely defined, perhaps due to an understanding that people should know it in the first place. The reality, however, is that many don’t. The term we’ll look at is ‘stock options,’ and we’ll be discussing everything from how they can affect employees who are offered them as a form of compensation, their value to investors, and their buying and sales options.

If you’re an outside to the world of investing, you may still be familiar with the term ‘stock options’ due to its presence in classified ads and job postings. It’s a term that’s thrown around frequently in a range of high-level positions, particularly those for executives and other skilled professionals. Does this make it something that’s outside the reach of most employees, and doe this really matter?

Stock options can be loosely defined as the ability or right for employees to purchase stock in their employing company, often at a significant discount from market rates. Employees, in exchange for their service to the company, are offered stock options – the ability to buy stock from the company itself, saving money on the market rate and securing a relatively lucrative long-term investment.

There are various reasons for a company to do this, which will be covered shortly. However, over the last three decades, stock options have moved from being a privilege reserved for management and high-ranking executives to a do-all compensation option for employees. Many companies now offer stock options to all of their salaried staff, regardless of their position or pay package.

It’s often classed as a benefit as such, as it allows the employee to gain a potentially lucrative link to a company that’s value is increasing quickly over time. The classic example is of the computer era’s Microsoft Millionaires – employees at Microsoft in the 1980s that, despite their lack of management credentials or developmental experience, became millionaires at IPO due to their stock holdings.

In the event that the company in question goes public, as Microsoft and others did in the 1980s, this means that its staff will be able to sell their stock options on the market and make a large profit. For thousands of employees in high-growth companies, this can transform a benefits package beyond a simple salary, and turn it into both a short-term compensation package and a long-term investment.

That’s the employee side of stock options, at least in their modern form. However, it’s interesting to note the reasons why an employer may wish to grant stock options to employees, particularly those that don’t work at a management level. Why would a company want to voluntarily divide equity in amongst its employees, particularly when equity can become a valuable factor down the line?

The reason, particularly in start-up companies, often has to do with expense management. In the early days of a start-up company, the value of stock is relatively low. As a result, companies with limited cash flow and capital reserves tend to use equity and stock options as an option for giving employees a ‘complete’ salary without having to sacrifice large amounts of their limited cash.

This has been particularly common in most technology companies of the past decade, where growth is generally rapid and monetization is thought of later in the company’s lifetime. In place of giving a large salary to employees – and in turn sacrificing its limited funding – technology companies offer stock options packages to employees in order to limit their expenses and capitalize on growth.

There’s also the loyalty aspect of stock options – one that’s been particularly important in companies aiming to keep high-level staff and high-demand personnel. Top executives are constantly receiving competitive offers from other companies, often with aggressively-priced pay packages. In an effort to keep employees loyal, many companies offer stock options at the completion of a work period.

Finally, there’s the mindset that can often come with stock options. While a pay check tends to be a short-term motivator for employees, a stock options package can make employees feel as if they’re a real part of the company. This in turn leads to greater accountability and responsibility, with most employees thinking of the company’s results ahead of their own, and vastly amplifying output.

There are a wide variety of stock options packages out there, and even more reasons to ‘cash in’ or hold onto your own stock options. As benefits and options vary from industry to industry, and even employer to employer, it’s difficult to give rough figures. However, remember that stock options are an opportunity to ‘go beyond’ a salary, and certainly an opportunity that’s worth considering.

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