The Stock Options Dictionary
The tech ecosystem includes a multitude of company types. However, what most of these companies have in common is an aspiration to go public or become acquired. At EquityBee, we often hear about employees wanting to know more about options, the same way they would about pension or insurance. Some go as far as ignoring their options package rather than dealing with it. That’s a shame, because it could be the key to making their next financial jump. Therefore, we decided to create a stock options dictionary, to help you gain a better understanding of this field and its lingo.
Definitions are presented alphabetically, except for the first:
Simply put, stock options give employees the right to buy company stock. They can buy the stock at a predetermined price (AKA ‘strike price’). However, there’s no obligation to ever exercise the option. Normally, the company will bundle employee stock options under contracts, each comprising an agreed-upon number of shares. To learn more about stock options, check out Employee Stock Options – The Beginner’s Guide Part 1.
A 409A is an assessment of a stock’s worth used for companies that are not traded publicly. Public companies list their share prices and are subject to supply, demand and market fluctuations. However, information on the value of a single private company’s share is not as easy to attain. The term 409A refers to a section of the American Jobs Creation Act of 2004. According to 409A, each company must provide a valuation every 12 months and when it closes a new financing round.
An angel investor is a private person, usually with a high net worth. These investors invest in a company at its earliest stages in exchange for equity or as a convertible loan. Angel investors usually know the founders on a personal level. Therefore, they make the investment out of faith in these persons, and not necessarily for the potentially high returns.
When using the graduated vesting method (see definition), the first part of the vesting period is known as the cliff. This means that the company will start giving employees their benefits only after that period has passed. However, once the first vesting period is over, employees will receive a large chunk (normally 25%) of their stock options at once.
As opposed to graded vesting (see definition of ‘vesting’ below), which gives employees benefits gradually, cliff vesting gives employees their full benefits once they’ve completed their vesting period. For example: If the vesting period is five years, the employee would be eligible for all benefits at the end of the five years. However, if they leave before the vesting period is over, they are not entitled to any benefits.
The commencement date is the date in which employee’s vesting period begins. More often than not, this is the employee’s first day on the job.
It is important to note that a commencement date is not a grant date. The grant date is the day in which the company (usually the board of directors) makes a determination to grant the options to the employee. It may be before or after the commencement date, but it is not a factor with respect to the vesting period.
Stocks are securities that represent partial ownership of a company. Stocks come in several varieties and common stock is one of them. Common stock give their owners voting rights on various company activities, such as replacing board members. Owners of common stocks may vote on any matter that is brought to a shareholder’s vote by the company. Companies may give common stock to individuals purchasing shares, investors such as VCs, angel investors and founding members.
Employee Stock Options Plan (ESOP)
An ESOP is a form of a statue that a company creates to award employees equity, alongside their salaries. This can be used to attract talent as it provides employees with the potential to share in the company’s success.
Exercising an option is the activation of the right granted in the options agreement. When an employee exercises an option, they may purchase shares at a predetermined price.
Exercise cost is the total cost that an employee will pay when exercising their stock options. Exercise cost is calculated by multiplying each option’s exercise price by the number of options exercised.
Fair Market Value
A fair market value (FMV) is the appropriate price for a certain property, such as company stock. The FMV can give employees an estimate of how much their options are worth at a given time. The person who determines fair market value could be one of two individuals: an independent appraiser or an employee of the company. The employee can determine FMV provided the company is still defined as a startup and they comply with 409A.
As opposed to cliff vesting, graduated vesting grants employees benefits (including options) over a period of time. For example, the company would give an employee 25% of their benefits after one year (see ‘cliff’), 25% more after two and the rest after three. Graduated Vesting ensures employee loyalty, while not withholding benefits.
A grant letter is a method of informing employees that the company is granting them rights to stock options. A grant gives employees options for a certain number of shares at the current market price. However, usually, options cannot be exercised immediately, but only after a predetermined time period.
ISO – Incentive Stock Options
ISO stands for incentive stock options. These types of options can’t be offered to non-employees, and they can’t be transferred to family members or friends. The profits on incentive stock options are taxable at the capital gains rate rather than the higher income tax rate.
In the stock options world, liquidity refers to a situation in which a stock could be converted into cash. Stocks are usually liquidated during a liquidity event, such as mergers & acquisitions (an ‘exit’) or an IPO.
The liquidation preference is a protocol that dictates the order in which a company pays stakeholders during a liquidation event. Usually, holders of preferred stock (see definition) will be paid before holders of common stock.
NSO – Non-qualified Stock Options
NSO, or sometimes NQSO, stands for non-qualified stock options. These types of options are typically offered to all startup employees at all levels. NSOs can also be offered to non-employees, consultants, and directors. The IRS considers NSOs as part of your compensation and charges you income tax on the stocks.
Post Termination Exercise Period (PTEP)
A PTEP refers to a predetermined time period in which an employee can exercise their stock options if they leave the company. To exercise, an employee must purchase the stock and pay all relevant taxes. If an employee does not exercise their options within the PTEP, they forfeit their rights to the stocks.
A preferred stock, another variety of stock, represents ownership rights, but not voting rights. However, owners of preferred stock have a higher claim when dividends are distributed.
Venture Capital (VC)
A venture capital firm (VC), or venture capitalist, is a person or organization that invests funds in a private company. A VC secures equity or other forms of ownership (such as a convertible loan) for their investment. Unlike an angel investor, a VC will usually invest only if there are sizeable returns on their investment.
Vesting is a mechanism that enables employers to retain employees by offering them a progressive number of options. Options are given based on the time spent with a company. Usually, vested stock options plans span several years. At the end of the vesting period, the employee becomes eligible for the full number of stock options. However, if the employee leaves before the vesting period is over, they forfeit some of the options and will not be eligible for the full amount. This is the most popular vesting mechanism for startup employees.
There’s no doubt that stock options are complex and could sometimes deter employees. However, we’re certain that the dictionary above will give you a better understanding of how stock options work.
All information provided herein is for informational purposes only and should not be relied upon to make an investment decision and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. Readers are recommended to consult with a financial adviser, attorney, accountant, and any other professional that can help you understand and assess the risks associated with any investment opportunity. Private investments are highly illiquid and are not suitable for all investors. Securities on the EquityBee platform are offered through North Capital Private Securities, member FINRA/SIPC.