How to Understand Private Company Stock Options
Stock options in private companies gained a somewhat bad reputation during the excesses of the 1990's. But there is still great value in private company stock options. It is a good way for a private company to give incentives to key employees and managers and still preserve cash. A share of stock can be thought of as owning a part of a company's debt. The more financially sound a company becomes and the more likely that the share of debt will be repaid the more valuable that share of the company's debt becomes.
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Instructions
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Acquire an understanding of how stock options work generally in investing. An option is a contract whereby the buyer of the contract has the right but not the obligation to buy (called a call) or sell (called a put) the underlying stock represented by the contract for a particular price (called a strike price or an exercise price) in a specified amount of time. The investor makes money on the contract when the share price rises above the strike price (in the case of a call) or below the strike price (in the case of a put).
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Understand the benefit of stock options to the employee. The number one benefit is that it gives the employee the opportunity to invest in their company with no start up cost and no risk. If the company does well and the stock goes up the employee can exercise the stock option and purchase the stock for much less than the current share price on the market. If the company does not do well and the share price drops the employee can choose not to exercise the option and they lose nothing.
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Realize the advantage of stock options for the private company that uses them to give incentives to their employees. The number one advantage is that the company does not have to deplete its limited cash reserves to pay out employee bonuses. The second advantage is that in most cases the company uses intrinsic value accounting which means all taxes are deferred on the pay out of the options until they are exercised.
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Consider the things which a company needs to take into account when creating their employee stock option plan. These considerations include the number of shares to be offered up, usually 5% to 20% of the company's total number of outstanding shares. Other considerations include when an employee is vested in the plan and that there is no implication in the plan of guaranteed employment. Also to be considered is how the plan is to be administered. A company must also determine an exercise price for the option as well as the term of the option.
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