How Stock Options Work

Overview

A stock option grants you the right, but not the obligation, to purchase shares at a fixed price. That distinction, a right rather than a guaranteed delivery, is what separates a stock option from an RSU or PSU, and it’s the reason a vested option isn’t automatically worth anything the way a vested share is.

Options weren’t always the alternative instrument they are today. Through the 1990s, they were the dominant form of long-term incentive at public companies, helped along by how they were accounted for. Under the rules in place at the time, a company granting options at the current stock price didn’t have to record any compensation expense at all, which made options look essentially free to issue, even though they carried real economic cost to shareholders through dilution. That changed in 2006, when new accounting rules required companies to expense stock options the same way they expense salary or bonus. Once options started reducing reported earnings like any other form of pay, RSUs, with their simpler and more predictable value, became the more attractive choice for most large public companies.

Options never lost their appeal everywhere, though. Pre-IPO and early-stage companies still rely on them as a primary incentive, largely because they don’t have the cash to compete on salary alone. A future right to buy stock at today’s price becomes a genuinely powerful recruiting tool when that stock has real room to grow, in a way it wouldn’t be at a mature, slower-growing public company.

What you actually receive at grant

On the grant date, you don’t receive shares, and you don’t have any decision to make about exercising anything either. You don’t have anything yet. What you receive is a contractual promise: if you remain employed through a defined vesting schedule, you will receive the right to purchase a set number of shares at a fixed price, called the strike price (or exercise price).

If your LTIP includes both stock options and RSUs or PSUs, don’t be surprised to see a meaningfully larger number of option units than RSU or PSU units in the same grant. That’s not a sign you’re getting more value from one instrument than the other. It comes down to how each instrument gets valued for grant-sizing purposes, which the mechanics below will make clear.

How stock options vest

Like most equity awards, a grant of stock options doesn’t become yours all at once. It vests on a schedule tied to continued employment. The range can be from immediate (or 0 years) to five years, but four years is the most common length. The options may vest in equal increments (say 25% for each of the four years) or in an unbalanced manner (either front-loaded or back-loaded).

For the purposes of our example, you have joined our startup Fathcarr Technologies and the company granted you 20,000 stock options with a four-year vesting schedule with 25% of the grant (or 5,000 options) vesting annually on the anniversary of the grant date. Your option grant is not a single entity, but four portions or tranches of options, each of which vests on a different date. Your option grant also comes with an expiration date (typically 10 years from the grant date). This means you must choose to exercise the options at any point after they have vested but before they have expired. Otherwise, you will forfeit these options.

What you see on your award/offer letter

How this plays out

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This is largely the same logic that governs RSU vesting: staying employed through each vesting date is what converts a portion of the award from forfeitable to non-forfeitable. Where options and RSUs part ways is what actually happens at the moment a tranche vests.

What actually happens when a tranche vests

When an RSU tranche vests, the shares are delivered to you outright, and you own them immediately. When an option tranche vests, nothing is delivered. Vesting only removes the condition of employment and thus activates the opportunity (or right) to purchase shares at the strike price (or exercise price). A vested option, in other words, isn’t a share. It’s a standing offer you can choose to act on (in whole or in part), or not. Vesting alone does not automatically cause or commit you to an action.

Where the value actually comes from: the spread

Say the strike price for Fathcarr Technologies was set at $10.00 per share. If the stock is trading at $10 or below, the option is out-of-the-money. It is not in your financial interest to pay $10 for something that is now worth $10 or less. There is no financial gain for you. If the stock has risen to, say, $15, the option is in-the-money, and the difference between the strike price and the current price, the spread, is the source of the option’s value. In this illustration, that spread is $5 per share on every vested unit.

This is why an option grant and an RSU grant of the same "size" are not equivalent in value. The RSU’s 4,000 units are worth 4,000 times the share price, whatever that price is. The option’s 20,000 units are worth 20,000 times the spread, which could be a meaningful number or could be zero, depending entirely on where the stock has moved since grant.

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Fathcarr stock price vs. strike price

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Fathcarr Technologies stock price over one year against a $10 strike price. Green shading marks the months the option is in-the-money; red shading marks the months it’s out-of-the-money.

An out-of-the-money option isn’t necessarily worthless, though. If there’s meaningful time left before the option’s expiration date, there’s still a chance the stock recovers and the spread turns positive. Being underwater today and being worthless are two different things.

Exercising: the step that makes it real

Turning that right into actual shares requires a separate action: exercising. Exercising is the act of actually paying the strike price to convert your right into shares (or, if a cashless exercise is offered by your company, having that cost netted out of the transaction automatically). Nothing happens automatically the way it does with an RSU vest. If you never exercise, you never own anything, no matter how large the spread has grown.

The clock that starts running at departure

Vested, unexercised options don’t last forever. Every option grant has an option expiration date, commonly ten years from grant for an active employee. However, the rules change if you depart your employer. Most plans dramatically shorten the exercise window upon termination of your employment, in some cases to as little as 90 days. Missing that shortened window means the vested options are forfeited entirely, regardless of how much spread had built up. This is worth sitting with for a moment: the standard ten-year timeline that governs an option while you’re employed effectively stops applying the day you leave, and a different, much shorter clock starts instead.

The through-line

A stock option is a right to buy at a fixed price, not a delivery of shares. It vests the same way an RSU does, but vesting is only step one. Value depends on the spread between the strike price and the market price, realizing that value requires the separate act of exercising, and the window to do all of this collapses sharply the moment you leave.