How Employee Stock Options Work

We were asked: "How do employee stock options work? Can you explain the term 'strike price' for me? My boss has referred to it in relation to incentive stock options, but our company isn't public yet."

Here's our answer. Let's say that you work for Rubber Chicken Catering Inc. (ticker: CHEWY). You're issued 1,000 employee stock options with a strike (or "exercise") price of $10 each. A few years later, the shares are trading at $35. At this point, you decide to "exercise" your options.

Since your options carry a strike price of $10, you're entitled to buy up to 1,000 shares at $10 each -- not the $35 that they're currently going for on the open market. If you exercise all of them, you'll fork over to your company $10,000 for 1,000 shares, and they'll immediately be worth $35,000. You can hang on to them as long as you like or quickly cash out for a $25,000 profit.

As you might suspect, it's not exactly quite this simple. There are many tax issues to consider, and your option plan might have some special features. Read the plan carefully. You might also read Kaye Thomas' book, Consider Your Options, or drop by his website at Fairmark.com.


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