We are told that we are compensated for this risk by being awarded employee stock options…. While I agree that it is indeed a strong incentive. For many, there is a fundamental misunderstanding about the underlying principles of stock options. Options, at their heart, are really a form of insurance.

Buyers of options pay a small, certain , amount of money in order to offset the impact of larger, uncertain changes in the price of a good stock, other asset, contractual right, etc. You either protect against possible downside risk or lock-in possible upside gains.

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I like this example because it does a good job of explaining the principle of options by taking it out of the context of employee stock or the stock market:. The first reputed option buyer was the ancient Greek mathematician and philosopher Thales of Miletus. Meaning: if you do a good job, you will be granted additional compensation as a reward.

Related Clauses

If this is the case, the only thing you are definitively being granted are the options to buy the shares of stock, and only the options. In your brokerage account, you buy the options themselves. At your startup company, you are granted the options at no cost to you. A possible opportunity, yes. A possible great opportunity, yes! A bonus? I have personally been involved with both types of startup companies. They care about risk profiles and their associated returns. A lot.

Stock Options come in two types: Incentive stock options ISOs in which the employee is able to defer taxation until the shares bought with the option are sold. The company does not receive a tax deduction for this type of option. Nonqualified stock options NSOs in which the employee must pay infome tax on the 'spread' between the value of the stock and the amount paid for the option.

The company may receive a tax deduction on the 'spread'.

Also in this issue:

How do Stock options work? An option is created that specifies that the owner of the option may 'exercise' the 'right' to purchase a company's stock at a certain price the 'grant' price by a certain expiration date in the future. Usually the price of the option the 'grant' price is set to the market price of the stock at the time the option was sold.

If the underlying stock increases in value, the option becomes more valuable. If the underlying stock decreases below the 'grant' price or stays the same in value as the 'grant' price, then the option becomes worthless.

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• Beware: Stock Options Will Expire If Not Exercised?
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They provide employees the right, but not the obligation, to purchase shares of their employer's stock at a certain price for a certain period of time. Options are usually granted at the current market price of the stock and last for up to 10 years.

Employee Stock Option (ESO) Definition

To encourage employees to stick around and help the company grow, options typically carry a four to five year vesting period, but each company sets its own parameters. Advantages Disadvantages Allows a company to share ownership with the employees. Used to align the interests of the employees with those of the company. In a down market, because they quickly become valueless Dilution of ownership Overstatement of operating income Nonqualified Stock Options Grants the option to buy stock at a fixed price for a fixed exercise period; gains from grant to exercise taxed at income-tax rates Advantages Disadvantages Aligns executive and shareholder interests.

Company receives tax deduction. No charge to earnings.

Employee Stock Option (ESO)

Dilutes EPS Executive investment is required May incent short-term stock-price manipulation Restricted Stock Outright grant of shares to executives with restrictions to sale, transfer, or pledging; shares forfeited if executive terminates employment; value of shares as restrictions lapse taxed as ordinary income Advantages Disadvantages Aligns executive and shareholder interests.

No executive investment required. If stock appreciates after grant, company's tax deduction exceeds fixed charge to earnings.