Exercisability of option: Overview, definition, and example
What is exercisability of option?
The exercisability of an option refers to the conditions under which an option holder can exercise or use their option to buy or sell the underlying asset, such as stocks, bonds, or other securities, according to the terms set in the option contract. The exercisability determines when the holder has the right to act on their option (e.g., buying or selling the underlying asset) and is usually defined by specific dates, events, or conditions outlined in the option agreement.
For example, a stock option might become exercisable only after the employee has worked for the company for a certain number of years or once a specific vesting period has passed. After the option becomes exercisable, the holder can choose to exercise the option (i.e., buy or sell the underlying asset) as per the contract.
Why is exercisability of option important?
The exercisability of an option is important because it determines the timing and conditions under which the holder can benefit from the option. It defines the window of opportunity during which the holder can take action, such as exercising stock options to purchase company shares at a specified price. The conditions set for exercisability can have a significant impact on the value and attractiveness of the option for the holder.
For businesses, clearly defining exercisability helps manage expectations around when employees or investors can act on their options. It can also provide incentives or retention strategies (such as vesting periods) to encourage employees to stay with the company longer. For option holders, understanding the exercisability criteria ensures they can plan effectively and decide when to exercise their options for maximum benefit.
Understanding exercisability of option through an example
A start-up company grants an employee stock options as part of their compensation package. The employee can exercise the options to buy company shares at $10 per share, but the stock options become exercisable only after three years of employment with the company (the vesting period). After three years, the employee can exercise the option at any time during the specified exercise window (e.g., the next two years) before the option expires.
In another example, a real estate investor has an option to purchase a property for $500,000, but the option becomes exercisable only after one year from the contract date. During that one-year period, the investor cannot exercise the option, but after the waiting period is over, they can choose to proceed with the purchase or let the option expire.
An example of exercisability of option clause
Here’s how this type of clause might appear in an option agreement:
“The Option granted herein shall become exercisable on the first anniversary of the Option Grant Date, provided the Optionholder remains in good standing with the Company. The Optionholder may exercise the Option in whole or in part at any time thereafter, subject to the terms and conditions set forth in this Agreement. The Option shall expire [X] years from the Grant Date unless exercised prior to such expiration.”
Conclusion
The exercisability of an option defines when and how the holder can act on their option, making it a key element of option contracts. It ensures that the holder understands when they have the opportunity to buy or sell the underlying asset, and under what conditions. For businesses, defining the exercisability conditions clearly helps avoid confusion and ensures that employees or investors know the terms of their options. For option holders, understanding exercisability helps them plan when to exercise their options to maximize potential gains or minimize risks.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.