Employee stock options can be a nice perk on top of a decent salary. They can also be poor compensation for lackluster pay. How employee stock options work.

Employers sometimes offer employees employee stock options. Those options can often represent a large percentage of the employees compensation. Sometimes, they even represent the largest share of compensation. And we’ve all heard stories of people who became millionaires just on their stock options.

Does that mean that employee stock options are always a good thing? In some situations, that’s true. But in others, it can be more hype than substance.

What are employee stock options?

Employee stock options, also known as ESOs, are stock options in the company’s stock granted by an employer to certain employees. Typically they are granted to those in management or officer-level positions.

Stock options give the employee the right to buy a certain amount of stock at a specific price, during a specific period of time. Options typically have expiration dates as well, by which the options must have been exercised, otherwise they will become worthless.

As an example, an employee may be granted an option to purchase 2,000 shares of the employer’s stock at $100 per share. This is referred to as the strike—or exercise—-price.

The employee will be unable to exercise the options until they are considered to be vested. This is similar to the vesting of employer matching contributions to a 401(k) plan. The stocks are not owned by the employee until the vesting period requirement has been met.

An employer can set up a multi-year vesting schedule. For example, the employee may be vested in 400 shares each year, over a space of five years. That means that the employee would be vested in the first 400 shares after one year of service, than 800 shares after two years, and so on, up to 2,000 shares. One of the purposes of a delayed vesting schedule is to keep the employee with the company for several years.

Each year, the employee will be able to exercise the options. That means that she can purchase—then sell—the stocks included in the option. Naturally, the options will only have value if the market price of the company’s stock is higher than the exercise price of the option.

In our example, the employee would not want to exercise the option until the market price of the stock exceeds $100 per share. This is another incentive for the employee—it will motivate her to perform at a higher level, in order to help boost the value of the company’s stock.

Let’s say that the value of the company’s stock is at $150 after one year. The employee can exercise the option to purchase 400 shares at $100, or $40,000. She can then immediately sell those stocks on the open market, for $60,000, leaving a $20,000 profit on the exchange. This is why stock options are often considered to be attractive method of compensation.

The entire transaction can be completed seamlessly by the employee. The employee only needs to decide to exercise the option, and both purchase and sale are handled by the employer. In such a situation, the employer may simply issue a check for the difference between the market price of the stock and the exercise price directly to the employee. The employee doesn’t have to come up with money out of pocket to exercise the option—the stock is already hers.

The benefits of employee stock options

There can be huge financial benefits that come from employee stock options. Higher-level employees can often convert their options into six-figure and seven-figure profits. In such cases, the profits from stock options can exceed their base salaries.

In some companies, key employees can receive options over many years, and even throughout their careers. That holds the potential for the employee to become a millionaire just on stock options alone.

In a strong, growing company that has a steadily advancing stock price, the payoff is almost unlimited. In such cases, it may be in the employee’s best interest to accept stock options in lieu of salary.

The pitfalls of employee stock options

As attractive as employee stock options can be, and have proven to be for a large number of employees, there are some significant downsides.

They are often offered by start-ups

Employee stock options are often offered by startup companies because they cannot afford to pay market level salaries. If you accept such a package from a startup company, and the company’s promise fails to live up to expectation, the stock options you receive may never exceed the exercise price. Should that happen, the options will be worthless.

The company’s stock could collapse

Sometimes this happens because an entire industry sector falls out of favor. Other times it happens because the company itself falls out of favor. It could be that one of its main products is overcome by a competitor. But it could just as easily be the result of a major lawsuit, or a sweeping regulatory change. Once highflying company stocks sometimes do go down—and stay down—for years at a time.

There could be a multi-year bear market in stocks

Even if a company is doing well, a multi-year bear market can depress its stock price. Should the market price of the stock become depressed after you are vested in the option, you will be unable to exercise the option. And if the market price of the stock doesn’t recover before the options expire, they will become worthless.

The employer can fail

It happens in the business world, the company collapses after making a series of bad business decisions. In most cases, employees will simply lose their jobs. But if you accept employee stock options in place of salary, you will stand to lose a lot more. The reduced salary that you accepted will never be replaced.

Termination prior to vesting

Since a major reason for providing employee stock options is to keep the employee with the company, you can lose the options if you quit or are fired before you become vested.

You could be putting all of your eggs in one basket

If you are counting on your employee stock options to fund your future, this could mean trouble if things don’t go according to plan. It’s important that you diversify your investment portfolio so you can handle whatever the future has in store. Using a robo-advisor like Wealthfront is an easy way to get started. With Wealthfront, you can create a custom portfolio to meet your specific needs. You can invest in categories you are passionate about like socially responsible investments (SRIs), technology ETFs, or healthcare ETFs. Or, if you want to keep things as simple as possible, you can use one of Wealthfront’s existing investment portfolios and tailor it to your needs by adding or deleting an ETF.

Should you accept stock options in exchange for a lower salary?

It’s likely that you’ve heard stories about people who became instant millionaires as a result of having employee stock options. And that certainly is true. But there are probably an equal number of cases where the options became worthless.

If you’re accepting a market level salary for your position, and are offered employee stock options, you should certainly accept them. After all, you have nothing to lose.

But if you are accepting a lower salary for stock options, be sure that you have a strong understanding of your employer’s business, and especially where they are heading. A well-positioned company with bright future prospects can turn stock options into a gold mine. But if the company is at all shaky, the options could well become worthless.

Do a good bit of homework, and get opinions from people who are in a position to know. The history of the company and its stock performance will hold a lot of clues. You will have to research your employer in much the same way that you would investigate a company that you were going to invest a large amount stock into.

When stock options are the major reason to accept a job offer, the history and prospects for the company’s stock are as important as the job itself.

Summary

Employee stock options can be a nifty perk, but be wary if they make up too much of your compensation package. Do your research and see if the stock is worth the investment.

If your employer is a startup, be careful and don’t put all yours eggs in a basket that might unexpectedly go kablooey. Stock options in a startup might make you a millionaire; in the worst-case scenario they could end up costing you money.

Read more:

Related Tools

Recommended Investing Partners

  • Recommended M1 Finance gives you the benefits of a robo-advisor with the control of a traditional brokerage. M1 charges no commissions or management fees, and their minimum starting balance is just $100. Visit Site
  • No Minimum Low-fee robo-advisor with no minimum investment. Creates fully-automated portfolios based upon your desired allocation. Visit Site
  • $500 Minimum Wealthfront requires a $500 minimum investment and charges a very competitive fee of 0.25% per year on portfolios over $10,000. Visit Site

About the author

Total Articles: 152
Since 2009, Kevin Mercadante has been sharing his journey from a washed-up mortgage loan officer emerging from the Financial Meltdown as a contract/self-employed “slash worker” – accountant/blogger/freelance web content writer – on Out of Your Rut.com. He offers career strategies, from dealing with under-employment to transitioning into self-employment, and provides “Alt-retirement strategies” for the vast majority who won’t retire to the beach as millionaires. He also frequently discusses the big-picture trends that are putting the squeeze on the bottom 90%, offering work-arounds and expense cutting tips to help readers carve out more money to save in their budgets – a.k.a., breaking the “savings barrier” and transitioning from debtor to saver. He’s a regular contributor/staff writer for as many as a dozen financial blogs and websites, including Money Under 30, Investor Junkie and The Dough Roller.