Stock options: Overview, definition and example
What are stock options?
Stock options are financial instruments that give an individual the right, but not the obligation, to buy or sell shares of a company’s stock at a predetermined price (called the exercise price or strike price) within a specific time period. Stock options are often used as a form of employee compensation or incentive, allowing employees to benefit from the company’s potential growth in stock value. There are two main types of stock options: call options, which give the right to buy stock, and put options, which give the right to sell stock.
For example, an employee may receive stock options that allow them to purchase company stock at $50 per share, even if the stock price rises to $100 per share in the future.
Why are stock options important?
Stock options are important because they provide a way for companies to attract, retain, and motivate employees by offering a financial stake in the company’s success. They align employees’ interests with the company’s performance, as employees can benefit directly from an increase in the company’s stock price. Stock options also provide a potentially lucrative opportunity for employees if the company’s value increases, while allowing the company to conserve cash by offering stock-based compensation instead of higher salaries.
In contracts, stock option clauses outline the terms under which stock options are granted, exercised, or vested, ensuring both the employer and employee understand the rights and responsibilities involved.
Understanding stock options through an example
A technology startup grants stock options to its employees as part of their compensation package. The options allow employees to purchase stock at $10 per share, and the options vest over four years, meaning employees must stay with the company for a certain period before they can exercise the options. After three years, the company’s stock price rises to $30 per share. Employees who exercise their options can buy stock at $10 and sell it at $30, realizing a profit.
An example of a stock options clause
Here’s how a stock options clause might appear in a contract:
“The Company grants the Employee stock options to purchase 1,000 shares of Company stock at an exercise price of $10 per share. These options will vest in four equal installments, with 25% of the options vesting on each anniversary of the grant date. The Employee may exercise the options at any time after they have vested, but no later than 10 years from the grant date, subject to the terms of the Company’s stock option plan.”
Conclusion
Stock options are a valuable tool used by companies to incentivize and reward employees by providing them with an opportunity to participate in the company's financial success. By offering stock options, companies align employee interests with corporate performance, motivating employees to contribute to the company’s growth. A well-drafted stock options clause clarifies the terms and conditions under which options are granted, exercised, and vested, ensuring that both parties understand their rights and obligations.
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.