Every so often, my company grants options to employees. And, also, every so often, an employee with options leaves and has to decide whether or not to pay the exercise price and exercise their options. In both of those instances, I find myself explaining “how do options work”. The first time, it’s generally because the person never received an explanation and the second time it’s because they did (from me, when they received the option grant) but have forgotten because, hey, it’s been a few years.
So here, in a brief article, is the explanation.
No, no! Just kidding! I mean, time is a good chunk of the answer, in a conceptual sort of way, but it isn’t the entire answer.
Here is the entire answer, albeit still at a high, super-simple, level…. The whole idea behind options having any value is that the company believes that, over time, the value of the company will go up, in no small part due to all of the hard work you and your co-workers are doing. And as the value of the company goes up, the fair value of the company shares, that is, the share price will also go up. But even as the share price is going up, your exercise price (that’s the price you will pay to buy the share) is staying exactly the same. It looks like this:
Now, let’s assume that you hold 10,000 options. One fine day, you come into the office and receive the news that the company is going public or is being bought out by Google or some other amazing exit. Or you wake up one fine day and receive the same news, but it is about your former employer where you hold shares because you exercised your options when you left.
It is time to cash in. 🙂
To exercise your options, you have to pay $10,000 (10,000 options at a $1.00 exercise price). So you either paid that when you left and exercised your options or you will need to pay that now. But then, you whip around and, BAMMMM! sell those shares at the market price, of $70,000 (10,000 at a $7.00 price per share (PPS)). You have netted $60,000!
Or, in the case of an IPO, you can hold onto the shares as an investment.
In reality, this process by which you exercise your options and sell will generally be worked into the whole exit process and you will not be required to do any scurrying to buy or whipping around to sell.
And then you get your net cash, pay the taxes (sigh….) and figure out what to do with the rest. Nice problem to have, no?
Now, of course the caveat: this normally does not happen. Anyone who establishes a startup or works for one hopes it will but, more often than not, there is no fat exit. But when it does happen, that is what is going on.