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“So are you gonna take your options, or what?”

My coworker raised his eyebrows over the rim of his coffee cup. I had just told him that I accepted a new job. I thought the big decisions were over. Not so! I still needed to figure out what to do about my stock options. And I didn’t even know what they were.

What is a stock option?

Imagine that there’s a cafe in your neighborhood, and you go there every day to get your favorite donut. One day, you’re running late to get your donut, and you’re dismayed to discover when you arrive that all of the donuts are gone! But you got lucky: the owner realized that you had not come in yet, and she set a donut aside for you.

You don’t own the donut, and you still have to pay for it. But since you’re a loyal customer who reliably buys that donut, the owner set it aside so that you would have the option of buying that donut even if the cafe sold out of all the other donuts.

Stock options work kind of like this. If you get stock options as part of your compensation, that means that in exchange for you being a reliable employee, the company will set aside some shares of its stock for you to buy later, if you want to. You don’t own them, and you still have to pay for them. But they’re reserved for you.

When do I get my stock options?

You usually don’t get all your stock options immediately. There are three important timelines for your stock options: the cliff, the vesting period, and the exercise window. 

The cliff is the amount of time you have to work at a company before you get any stock options. See, if you had gone into that cafe for the very first time to get a donut, you would have been out of luck: the cafe would have sold out of donuts. In fact, even if you had gone in there a couple of times, the owner might not have set aside that donut for you. But since you are a reliable customer, the owner did you a favor and set aside the donut. But in order for that to happen, the owner had to know about you and expect you to come in for the donut.

Stock options aren’t exactly like this: they are not favors. They are a part of your compensation package and you are entitled to them. But, you have to be at the company for some period of time (usually a year) before you get any of your stock options. This is because the company wants to make sure you are reliable before they give you special offers on any of their stock.

When you get the stock options, that is called vesting. When you reach the cliff at, let’s say a year, a year’s worth of your options will vest. That means that they are now set aside for you to buy, if you want to. Usually after the cliff your options vest on a monthly basis—so, every month, another month’s worth of options will go into the pool of shares that are set aside for you. The vesting period is usually four years. At four years all of your options will have vested. At that point, you don’t get any more options unless your compensation package has changed to give you more option shares.

But you can’t just buy the shares whenever you want. There is an exercise window, usually a two week period every quarter, in which you can purchase some or all of your options. Once you purchase those shares, they belong to you. Even if you leave the company, you own your shares. If you leave a company between exercise windows, you still get one last chance to exercise during the next available exercise window. If you leave a company and decide not to exercise your options, those options will be cancelled. Suppose you didn’t show up to your favorite cafe for hours..and hours…and finally, in the afternoon, the owner gave up on you, took your saved donut, and put it in the sale cabinet for someone else to buy. Now, you don’t have any better chance at the donut than someone who walked in off the street. When your options get cancelled, you no longer have those shares reserved for you.

If I have to pay for my stock options anyway, why don’t I just buy shares on the stock market?

Generally, employees get a special strike price on company stock.This is how much you will have to pay for each share of your stock options. The earlier you join the company the lower your strike price, but almost always a stock option costs less for employees than the stock is valued for on the market. So if the company is public, you can exercise your options, then turn around and sell them on the stock market for a profit. In this way, stock options can add huge value to a compensation package. At public tech companies, it’s not unheard of for an employee to make an annual salary of $X and, in addition, sell some stock options for at least that much each year.

What if your company is private? Well, you can’t sell your shares on the market yet. But you also can’t buy shares on the market. Being an employee or an investor are the only ways to get stock in a private company. Later, if the company does go public, you can sell your shares (usually after some window of time after the IPO)*. If you think the company will go public and the stock will go for more per share than your strike price, then it may be worth it to exercise your options.

*Theoretically it’s also possible for a company to issue cash dividends to shareholders, so they make money without selling their stock. This happens relatively rarely in tech, so we’re going to focus on selling shares as the way to profit from them for this post.

Should I exercise my options?

This is a risk calculation, and the answer is not the same for everyone. If you work for a public company, the answer is easier to figure out. Look at the current share price for your company on the stock market. Is it higher than your strike price? If so, you can exercise the options today, sell them tomorrow, and make a profit. If not, you can exercise and then sell if the market share price goes up, or you can choose not to exercise if you don’t think the price will go up enough to turn a profit for you.

For private companies, the calculation is a little harder. You don’t know if the company will go public, when it will happen, or what price shares will sell for. You have to decide if you think that exercising your options will be a worthwhile investment.

Suppose you have 250 options at $4 a share, so your options will cost you $1000. If you invest that money in, say, the American market and get around a 6% return on investment, you’ll earn $60 in the first year. The next year this compounds, so you make your return on $1060—an additional $63.60. And so on. You give up these annual earnings for each additional year that you could have invested that $1000 in the market, but you didn’t because you bought the stock options.

Suppose the company finally IPOs after 5 years, and the stock price stabilizes at $10 per share. You stand to make $1500 on your shares! 250 x $10 = $2500, minus the $1000 you spent to buy the options in the first place. By comparison, in those five years if you had invested the money in the market, you would have made 1000 x (1.06^5) – 1000 = $338.22. In this case, your stock options were the better choice from a financial perspective. It’s not unheard of for employees to pay $4 per share for options while the market share price is $40, or even higher. So although an employee can almost never retire on a stock option payout, it can provide a hefty return…sometimes.

But suppose it takes the company 16 years to IPO. If the stock price stabilizes at $15, you still make $1500 on the shares. But you could have invested in the market instead and made more money: 1000 x (1.06^16) – 1000 = $1540.35. And this is still not a terrible case scenario. What if the company goes bankrupt, doesn’t IPO, or it does IPO but a change in the business climate forces its stock price lower? Stock options, like any investment, include risk. And it’s often more risk than you’d shoulder with a diversified investment portfolio.

Did you exercise your options, Chelsea?

It’s a mystery! I’ll let you guess ;).

In Conclusion

Stock options are shares of company stock that are set aside for you as an employee to buy if you want to. Usually you have to serve a period of employment time called the cliff, at which point your options will begin vesting and you can purchase them during an exercise window. You often get to buy the stock at a strike price that gives you a discount from the market share price—or at least a discount from the market share price that the owners are hoping for, if it’s still a private company. Deciding whether to exercise your options is a personal financial decision that, especially if the company is private, requires some serious thought.

You may also be interested in:

Advance Your Tech Career: A Guide to Evaluating Total Compensation

Additional Resources that I found helpful:

Quora: What happens to your stock options if you decide to leave a company

L.A. Times: A somewhat sensationalized but still informative story about how some employees chose whether to exercise their stock options