Stock Options?

Factual Questions
1

Knowing how erudite most of you are, and many presumably are used to juggling their millions of dollars, could someone please explain the concept of stock options to me? Now I’m quite certain its a complex issue, and there are many complicated specifics, so I assume its not going to be a straight answer. I’m ok with that! :wink:

Anyways, how do stock options work in publicly held, versus pre-IPO companies? Do private firms offer stock options? If so how are they useful? Are stock option lucrative in any way other than when you liquidate them? If a company is in a pre-IPO stautus how does one valuate the stock options? What are good specifics of a stock option plan? Any other tidbits of info you’re willing to provide I appreciate. One stock specific question, how exactly do dividends work and why don’t all stocks give them? How should one manage the choice between stock options and a 401k?

Is that enough to chew on? Thanks for the help.

2

As the proud owner of some stock options, I can shed light on some, but not all, of your questions.

Basically, I worked for a company that was purchased by another company. The purchasing company was not public. They gave us all a bunch of options.

An option is basically an agreement that says “We’ll sell you x shares of stock at a price of y, regardless of what the price on the open market is.” I think in most cases, or at least in mine, the options vest over a period of time. Mine vest at a rate of 1/48 of the total # of options each month. That basically means that I can’t buy the total # of options they gave me until I work here for 4 years.

It being a private company, the options were basically worthless unless and until it became a public company. The price on the options were based on what people thought the company might be worth at the time. Meaning: they guessed, and came up with a number.

With normal stock, you can do one of two things at any time. You can buy it, or you can sell it. With options, you don’t buy them, per se. You “exercise” them. Meaning, you say “Hey! I have this contract that says I can buy this stock at $1.50 even though it’s currently trading at $150! I wanna do it!” So you do it, and poof! The things show up in your brokerage account, and if you’re lucky like me, you get to pay AMT tax on the damn things. Then you can sell 'em anytime you want, just like if you had bought the stock normally (ie, without having options.)

You have to come up with the money to buy the things yourself. IE, in the above example, I’d have to come up with $150.00 if I wanted to exercise 100 shares and my price was $1.50. Many companies offer a deal where you can sell a percentage of shares in order to pay the cost to exercise what’s left.

When my company was bought, yet again, by a public company, my options suddenly became worth more than the paper they were printed on. Yipppeee! The same thing would have happened had we ever really IPO’d.

I have both options and a 401k. I pump a pile of money into the 401K, as it’s tax-free and the options are not. They’re not the same thing at all, so I can’t really compare the two.

I have no clue about dividends. I didn’t know jack shit about stock until my options became worth something, and since then I’ve learned just enough so that I can figure out how to manage mine.

3

I know that publicly held companies issue stock options, because my company gives them out as bonuses. It’s pretty straightforward; you’re given x number of options offered at a set price. You then have up to 10 years to decide when to exercise your option to buy.

The benefit to you is that you don’t have to spend any money to exercise your options. All you have to do is wait until the current stock price is above your option price, then sell. You get the sale price less the option price.

Of course, if the stock price never goes above the exercise price during the life of the option, then nothing happens. The options expire, and you’re neither richer nor poorer than when you started out.

I don’t think companies have option “plans”; I’ve only heard them offered as rewards or bonuses to top performers or loyal employees. Maybe you’re thinking of ESPP (employee stock purchase plans). That’s a whole 'nother kettle of fish. In that situation, you contribute money into a fund for a predetermined amount of time (usually either 6 or 12 months). At the end of the term, that money is used to purchase shares of the company’s stock. The price of stock offered to you is some percentage less (usually 15%) of the lowest price of the stock at two “target dates” (usually the first and last day of the period).

This is also a nice set up. If you sell your stock immediately upon purchase, you’re guaranteed a profit at least equal to the discount rate offered by the company. This system really works great in company’s whose stocks are steady climbers.

Dividends–this is a share of the company’s profits, paid out per number of shares held. You might see that the Acme Corporation paid a dividend of 2 cents/share. If you own 10,000 shares, you get $200. Whether or not dividends are paid is determined by the company’s board of directors. If you have a pretty liberal BoD, they may decide to reward the investors if the quarters been really good. On the other hand, they may decide to reinvest the profits into the company, so no dividends for you. And if the company is doing badly (or even just average), no dividends for you!

There is no comparison between a 401(k) and a stock option. A 401(k) is a retirement instrument; your contributions are pre-tax, and your interest returns won’t be taxed until you retire and begin withdrawing money. As I said above, a stock option is not something you can get, it’s something your company decides to give. Think of it as windfall; it’s nice to receive, but don’t go planning your finances around it.

4

I want to clarify, since Guy & I said basically the opposite thing on this issue.

You can do the above, but that’s only if you want to buy and sell on the same day. There’s a huge tax advantage to NOT doing this - if you exercise (ie, buy) and hold for a year, you get a big tax break.

I don’t consider being able to sell without expending the $$ to buy a particular benefit of stock options. I consider the primary benefit the fact that (in my case at least) the options are offered to me at an incredibly low rate considering what the stock is actually trading for. IE, I make a lot of $$ off of them. But I realize this is not necessary the case with all options.

Also, my company does have an option plan. We get more options every year at review time. It’s part of the benefits package. We also have an ESPP, which is separate and a whole different beast than the options.

5

Stock options are the right to purchase shares of stock at a given pre-determined price. You would realize a gain if you were to buy the options and then sell them when the actual trading price is higher than the price you paid. Of course, you would suffer a loss if you were to sell them for less than you paid for the options. I’m not familiar with options in a company that is not publicly traded.

A simple way to describe dividends is that they are part of the profits that a publicly held company is returning to its owners (shareholders). Among the various reasons a company may not give dividends is that there may not be any profits to distribute, or the company’s management feels that the profits are better spent invested in the company, rather than returned to shareholders.

Stock options and 401K plans are different animals. Assuming your company matches part of your 401K withholdings, you should be investing in your company’s 401K plan regardless of your other investment opportunities. Not only do you get the immediate gains from the company match, but you defer paying income tax on your withholdings until you start withdrawing from the 401K, hopefully at retirement.

6

Stock options are shares of stock that you are allowed to buy at a price set the company granting them. Often the shares vest (become exercisable) at a future time. If the stock is worth more when they vest than the option price, you can buy them, then sell them for the going rate and pocket the difference.This is often done as a “cashless transaction” by a broker. The broker buys the stock in your behalf at the option price, sells it at the going rate and sends you a check for the difference - less the broker fee and a small interest charge on the purchase money. This is called an incentive option. There are other types, but this is the one I am familiar with.

Options are often a very lucrative deal. In my case I have been able to fund what should be a decent retirement (God willing and the stock market don’t crash) with options.

Regarding 401k and options. These are separate items. The 401K is pretax money you contribute, often with a match by the company. You don’t pay a tax until you take the money out.

Any profits you make on incentive options are taxable - as ordinary income - if you buy and sell quickly, or as a long term capital gain if you hold it a year (as I recall).

7

Just wanted to point out a couple of things:

Athena wrote:

This is only true if you want to own the stock for a while. There is a thing called a cashless exercise where the firm that performs the exercise function loans you the money (just for a few minutes). They exercise the stock in your name with their money and they give you the difference (less their exercise fees). If you think the stock price is not moving or is going down, this is the best way to exercise your options. If the price is going up and looks like that trend will continue, assuming you’ve reached the end of your option period, then you’re better off purchasing the stock at your option price and holding it. This approach can have a positive effect on your capital gains.

If you’re dealing with a pre-IPO, then the options may be completely worthless. I know a company that gave out options like halloweeen candy. The option price was $2. A year and a half later they went public with an introductory price of $22. It quickly zoomed up to over $40 per share. “Fan-freaking-tastic!”… all the employees thought. However, they were not allowed to exercise until a year later. Here it is a year later and the stock price is below $1.50. Sometimes life sucks!

I know another case where a pre-IPO company was giving out options as an incentive to get and keep people because they couldn’t afford to pay people competitive salaries. Two years later the company folded before they ever went public.

That should never be a choice in a good company. Stock options are for incentives and rewards. They should be completely independent of your 401K. Being given options is always a good thing. In the best cases, as with early DELL Computer employees, they can make you a multimillionare. In the worst case, they are at least a nice pat on the back for a good job. If you’re somehow being asked to trade options against real benefits (401K, salary, etc.) I would advise extreme caution.

8

Well, stock options aren’t really that complex. Of course, I don’t think that writing modem protocol subroutines in C is all that complex, so you may want to take that opinion with 23.9 mg of NaCl…

An option (generic, not necessarily stock) is a contract to reserve the right to buy something at a later date. You like my 1973 Chevy Molotov (the car with the rag in place of a gas cap), but haven’t got the outrageous price that I’m asking for it right now? “Here’s USD 10; don’t sell it until Friday noon.” You’ve bought an option to buy my car from me; I can’t sell it to anybody until after Friday noon.
Whether you buy it or not, you’re out the sawbuck (unless you are significantly larger and/or better armed than I).

A stock option from a company to you is the same idea (there are also publicly-traded options written by others, but that’s another story).

Options in publicly-traded companies are usually (but not always) granted at “fair market value”; i.e., what the stock’s trading for right now (“right now”, in this context, probably means “at the close of business on the day before the grant”). If an option is granted below fair market value, it’s income to the grantee and an expense to the grantor; there are acounting and tax rules to cover that situation (please do not ask me to explain those). Options may be granted above fair market value as an incentive to executives to boost the stock price.

So, you’ve gotten an option to buy 10,000 shares of Consolidated Fuzz common (symbol: CFUZ) at USD 1, expiring 24 May 2005. Since CFUZ is trading at USD 1 just now, you’re not going to make any money by exercising it. If, this time next year, CFUZ is trading at USD 10, you may decide to exercise your option; pay USD 10,000 to the company, it issues you 10,000 shares, you immediately sell them, and pocket USD 90,000. Or, maybe you don’t sell them (you don’t have to); you hang on to them until 2002, when CFUZ is trading at USD 100, sell them then, and pocket USD 990,000 (naturally, you pay taxes on the profit). If, OTOH, CFUZ still isn’t trading above USD 1 by the expiration date…well, life’s a bitch, and then you die.

Do privately-held companies offer stock options? Sure, all of the time; it’s cheaper than actually paying employees :). Generally, the privately-held firm is looking at a buyout or an IPO a few years down the road, when everyone holding the options expects to make out like bandits (of course, if the company doesn’t get bought out or undertake an IPO…like I said, life’s a bitch).

Stock options do not pay out until they’re exercised and the underlying stock is sold. As for deciding between options and 401(k), well, IANALIA.

Oh, dividends. Generally, a stock corporation is permitted to pay dividends out of retained earnings (there may be debt covenants in a particular instance that prevent it from doing so). Some companies do so, some do buybacks of their stock, some put earnings back into growing the company. There is never, that I can think of, a requirement that the company must do so on its common stock (there are other kinds of stock, on which it often is required). Basically, it comes down to:
[ol]
[li]How greedy the CEO is[/li][li]Whether he can think of anything useful to do with the cash[/li][/ol]

9

Of course you could be in unenviable position I’m in. I have the option to purchase company stock locked in at $39.50. Of course the stock is trading around $28.00 right now. Damn company screwed us out of profit sharing one year and offered up all these worthless options instead :mad:

10

Thanks, but I’ll stay with my position. Option price ~$4.50, today’s close at a hair under $105.

whooohoo!

11

As for the best strategy for exercising options, many people suggest exercising the options and buying the stock to hold on to it (expecting it to rise) and take the capital gains tax at the end of that year instead of taxing everything as income.

You should know that there are Non-Qualifying options (NQ) and Incentive Stock Options (ISO) which are treated differently for tax purposes. Most start-ups right now are giving ISO’s, whereas my company (large and established) gives NQ’s.

12

You can also buy and sell certain options themselves, without ever exercising them.

13

I knew that 401k’s and stock otions were different things, and by manage a choice I meant whether one should use limited resources to buy all the stock options offered (assuming you want to keep the stock and watch it grow, and not sell immediately for the cash difference) or to max out the 401k. This presumed one doesn’t have the funding to do both. I was wondering what factors could make buying the stock more practial han maxing out the 401k. I’m young so I imagine I’ll invest exactly what portion the employer would be willing match, no more, no less.

From what I’ve gathered so far, a stock option on a publicly held company is straight forward to manage. You spend that money on the stock at the promised price as long as the market value is higher. But if the option is available until 2003, why would you ever buy stock before 2003 unless you intend to sell it and pocket the difference on the spot. Is there a benefit to buying the stock at that price in 2001 if the market price is very high?

What about with a pre-IPO company, if you have options you haven’t exercised when it gets bought out or goes IPO do you still reap the rewards of those options? Essentially having the choice to buy stock in a privately held company seems to offer no reward until one of these 2 events take place, so why would you buy the stock at the option rice before these events were imminent?

14

The advantage is a tax advantage. If you exercise and hold for a year before selling, you pay significantly less tax. Oh yeah, the date of the intial option has to be 2 years before the sell date, too.

You definitely get the options when your company goes IPO. As you’ve divined, the options are worthless until then. So basically, you don’t buy the stock before it becomes public stock.

15

Athena wrote

Actually, the same tax benefit you referred to in your first paragraph is true here as well. If you are confident your company will liquidate (via IPO or acquisition), then there is good reason to buy your options early. As you pointed out, holding stock for one year (and owning the options for two years) makes it a long term gain, subject to capital gains, which are generally cheaper tax-wise. I have personally bought stock in three private companies I’ve been at in the expectation the stock would be liquid in the future.

Omniscient wrote

I’m not sure what’s going on here. I’ll make some assumptions: a) you’re at a public company. b) you’ve got some options as part of your employment. c) some of those options have vested. d) your question is “should I exercise those options and hang on to the stock?”

Assuming a-d hold, my answer is: wait until you believe the stock is as high as it’s going, and sell. Don’t hold the stock, just take the sale cash. If you believe the stock will continue to rise, don’t exercise yet.

16

Since you’ve stated that you’re young, I’ll make the traditional pitch and tell you to focus on your 401(k). It’s advantage is (a) its diversity of investments spread out your risk, and (b) its longtime investment tends towards an excellent return. Stock options, like short-term stock speculation, are a crapshoot. Maybe they’ll go up, maybe they won’t. And, as Athena pointed out, buying and selling options in the short term have significant tax implications.

I don’t understand one thing, though. You keep asking about buying stock options. You’re not talking about buying futures, are you? I’ve never heard about buying stock options; I’ve only known them to be something given to employees as a perk.

17

Actually, there are two types of stock options. The ones most companies give their employees are “calls,” which allow you to buy the stock at a set price. If the actual stock price is higher than the option price, you make out. If it’s lower, you lose (especially when you buy the options in the marketplace).

You can also write call options (as opposed to buying them). You would get paid a set amount for the options (determined by the marketplace). If the stock price drops below that price, you win. If it goes above the option price plus the money you were paid for the option, you lose.

The loss is greatly affected by whether you’re “covered” (i.e., you own shares in the stock you are writing the option for). If you’re covered, you already have the stock and your loss is limited. If you don’t own the stock, you have to go out and buy it – at the now high price – and sell it at a lower price. Generally, writing covered calls are considered a way of insuring your profits if you expect the stock price to go down and are a fairly conservative strategy. Writing uncovered calls are considered very high risk, since your potential for loss in infinite.

The second type of option is a “put,” which works the opposite of a call. It gives you the right to sell stock to someone at a set price. If you buy a put, you expect the stock price to go down. If the stock falls below the value of the put, you can buy the stock at the lower price (say $20) and sell it for the value of the put (say $25). If the stock rises, the option will expire and you’ll lose the price of the option.

If you think a stock is going up, you can write a put. You get the price of the put. If the stock drops, though, you will have to buy the $20 stock for $25 (or worse – $0 stock for $25).

18

BTW, options are traded just like stocks. For instance, currently GE June $35 call options are selling for 16 5/8. What this means is that if you want to buy a call option for 100 shares of GE stock, you can get it for $16.63 per share. This would indicate that GE stock is currently selling around 51 5/8 (a quick look shows it’s currently 51 7/16). Since it’s close to the expiration date, the option price is pretty close to the current price. However, if you bought that particular call a couple of months ago, at a price of $4-5 (I don’t have any idea what the actual price is), you stand to make some money just by selling the option.

When options are granted to employees, there may be a stipulation that they can’t sell the option itself (or it just may be the case that they make more money by using it to buy the stock). And there may be some differences in how they’re created, since their expirations are usually much longer term than other options.