Cash or stock options

How do stock options work?

The price the company sets on the stock (called the grant or strike price ) is discounted and is usually the market price of the stock at the time the employee is given the options. Since those options cannot be exercised for some time, the hope is that the price of the shares will go up so that selling them later at a higher market price will yield a profit. You can see, then, that unless the company goes out of business or doesn't perform well, offering stock options is a good way to motivate workers to accept jobs and stay on. Those stock options promise potential cash or stock in addition to salary.

Let's look at a real world example to help you understand how this might work. Say Company X gives or grants its employees options to buy 100 shares of stock at $5 a share. The employees can exercise the options starting Aug. 1, 2001. On Aug. 1, 2001, the stock is at $10. Here are the choices for the employee:

The first thing an employee can do is convert the options to stock, buy it at $5 a share, then turn around and sell all the stock after a waiting period specified in the options' contract. If an employee sells those 100 shares, that's a gain of $5 a share, or $500 in profit. Another thing an employee can do is sell some of the stock after the waiting period and keep some to sell later. Again, the employee has to buy the stock at $5 a share first. The last choice is to change all the options to stock, buy it at the discounted price and keep it with the idea of selling it later, maybe when each share is worth $15. (Of course, there's no way to tell if that will ever happen.)

Whatever choice an employee makes, though, the options have to be converted to stock, which brings us to another aspect of stock options: the vesting period . In the example with Company X, employees could exercise their options and buy all 100 shares at once if they wanted to. Usually, though, a company will spread out the vesting period, maybe over three or five or 10 years, and let employees buy so many shares according to a schedule. Here's how that might work:

You get options on 100 shares of stock in your company. The vesting schedule for your options is spread out over four years, with one-fourth vested the first year, one-fourth vested the second, one-fourth vested the third, and one-fourth vested the fourth year. This means you can buy 25 shares at the grant or strike price the first year, then 25 shares each year after until you're fully vested in the fourth year.

В­Remember that each year you can buy 25 shares of stock at a discount, then keep it or sell it at the current market value (current stock price). And each year you're going to hope the stock price continues to rise.

Another thing to know about options is that they always have an expiration date: You can exercise your options starting on a certain date and ending on a certВ­ain date. If you don't exercise the options within that period, you lose them. And if you are leaving a company, you can only exercise your vested options; you will lose any future vesting.

One question you might have is: How does a privately held company establish a market and grant (strike) price on each share of its stock? This might be especially interesting to know if you are or might be working for a small, privately held company that offers stock options. What the company does is to fix a price that is related to the internal value of the share, and this is established by the company's board of directors through a vote.

Overall, you can see that stock options do have risk, and they are not always better than cash compensation if the company is not successful, but they are becoming a built-in feature in many industries.

For more stock market and investing information, check out the links on the next page.

More to Explore.

Related Content.

Recommended.

Get the best of HowStuffWorks by . Keep up to date on:

How do stock options work?

Job ads in the classifieds mention stock options more and more frequently. Companies are offering this benefit not just to top-paid executives but also to rank-and-file employees. What are stock options? Why are companies offering them? Are employees guaranteed a profit just because they have stock options? The answers to these questions will give you a much better idea about this increasingly popular movement.

Let's start with a simple definition of stock options:

Stock options from your employer give you the right to buy a specific number of shares of your company's stock during a time and at a price that your employer specifies.

Both privately and publicly held companies make options available for several reasons:

They want to attract and keep good workers. They want their employees to feel like owners or partners in the business. They want to hire skilled workers by offering compensation that goes beyond a salary. This is especially true in start-up companies that want to hold on to as much cash as possible.

Go to the next page to learn why stock options are beneficial and how they are offered to employees.

More to Explore.

Related Content.

Recommended.

Get the best of HowStuffWorks by . Keep up to date on:

Cash-Based Option.

DEFINITION of 'Cash-Based Option'

A type of option which is always settled in cash. Upon exercise, the net value to the involved parties are calculated and a cash payment is made to settle the difference. This option is advantageous for investors who want to capture movements in stock prices only, and not be required to enter a position following the exercise of an option.

BREAKING DOWN 'Cash-Based Option'

For example, let's say you purchase a cash-based call option contract with a strike price of $55. You exercise the option when the underlying stock price reaches $60 per share. Since one contract is for one hundred shares, the net value to you is $500 ( (60-55) x 100 ). In this case, you will receive $500 in cash, instead of being required to purchase 100 shares of stock for $55.

Cash vs. Stock Options at a Startup: Which Should You Choose?

Congratulations, you’ve just landed a job at a tech startup. All the perks you have read about are true: there are free snacks, you can wear jeans to work, and you have an unlimited amount of vacation.

When you get your offer letter, you diligently negotiate your offer (Sheryl Sandberg said to, after all) and the company counters with an offer for more cash, less equity. Or perhaps more equity, less cash.

Whatever the offer, now you have to choose between dollars in your account today and stake in the company that could pay off big time tomorrow — or not at all.

How do you evaluate which of the two is worth more, and ultimately, which to take?

Make sure it’s even possible to pay your expenses with less cash.

If you’re considering a pay cut as a trade for more equity, the first thing to consider is whether you can actually pay your monthly expenses, like rent, food, transportation, and other life costs, with the amount of cash you’re offered. Chances are if you’re headed to a technology startup, you may be living in San Francisco or New York City where rent is high and the offer should reflect that high cost of living.

In February 2016, the average rent for a one-bedroom apartment in San Francisco was $3,096; the average rent for a one-bedroom in a non-doorman building in Manhattan was $3,071.

Think about how long you’ll be at the company and investigate the vesting schedule for stock options.

Most companies will offer you stock options with a four-year vesting schedule and a one-year cliff. The cliff essentially means that you won’t have the ability to purchase any of your options before your one-year anniversary with the company. At the one-year mark, you’ll typically be able to purchase 25% of your options (if you choose) and the remaining equity will vest either monthly or quarterly for the next three years. In most cases, you’ll have the option to purchase 100% of your stock after four years with the company, or some percentage of that if you leave between one and four years.

The takeaway here is that the longer you stay with the company, the more equity you’ll have (up to a certain amount).

Evaluate the company’s potential for success.

If you’re joining a startup, let’s hope you believe it will be successful. Regardless, it’s important to keep in mind that stock options aren’t worth much unless something happens such as an IPO or an acquisition.

If it’s a company whose mission you can see carrying it places, more stock is a good way of making sure you get in on a good thing early. On the flip side, if you don’t know enough to evaluate the business, or you’re accepting the position as more of a career stepping stone, extra cash may be your move. If the business doesn’t turn out to be successful, that hard-earned equity will be worth nothing. Think about factors such as the size of the market the company addresses, the business model, and whether or not they are profitable.

Figure out if the alternate they’ve offered makes financial sense.

Calculating the tradeoff between stock options and salary can be tricky because it depends on a number of assumptions. Automated investing service Wealthfront explains how to calculate the amount of equity you should trade for salary, or vice versa, based on the stage of the company you’re joining. Before you make a decision, know whether the cash-for-equity number the company is offering is a fair exchange–and the company should be willing to share the information you’ll need to calculate that.

When it comes down to it, you’ll need to make a well-researched decision when choosing between additional salary and equity for your new startup job. Know what you can actually afford, whether this job will last you, at least, a few years, and whether the alternative compensation package you’ve been offered is actually comparable–as well as how much risk you’re willing to take on the company.

5 Finance Bloggers on Their Rock-Bottom Money Moments.

Hard vs Soft Credit Check: What’s the Difference?

7 Ways to Be Better at Your Finances.

Sign up for our newsletter.

Sign up for our newsletter.

Earnest in the Press.

“This student-loan startup says it has the killer feature to beat big lenders”