KNOW YOUR OPTIONS

By Andrew D. Lindsay, Director, Brand Mandrake

No longer a perk associated exclusively with upper management or those in the high-tech sector, stock options have become a common and crucial part of compensation packages across all industries and levels of seniority. Chances are you find yourself among the 1 in 5 employees being granted stock options from their employer. To make these options an effective part of your overall compensation package, it's essential to comprehend the ins and outs of the option world.

First, some basic definitions. A stock option is a right provided to an employee to acquire a set number of shares in their company, at a predetermined price, for a set period of time. The company providing the option is called the "optioner" and the third party (or employee) to whom the option is granted is the "optionee". 

Stock options have a set period during which they may be "exercised." The act of exercising an option means to elect to purchase the stock available under an option. The price at which the stock may be purchased is called the "exercise", "strike", or "grant" price. The difference between the "strike" price and market value of the underlying shares is referred to as the "spread". The attraction of options is the expectation that you will own options with a strike price well below market, and you can exercise them at a time that allows you to pocket the spread instantly.

Options are usually subject to "vesting" periods; limiting the ability to exercise these options for stock to certain, preset phases. The common vesting period is three to five years. During that time, only a predetermined portion of the options may vest on a staggered timetable, usually once a year. 

Organizations offer stock options to employees for several reasons. By not having to spend the cash dollars on straight salaries, employers can improve their liquidity and cash position. In today's highly competitive labour market, options are a common tool for recruiting and retaining employees, as those who wish to exercise their options must remain with the company until the options vest. 

For employees working in a hands-on work environment, where they enjoy more decision making power, this has spurred the growth of options in the compensation mix. Having a stake in the company's future causes workers to play a larger role in the organization and stay more focused on fuelling growth and profits. There is the obvious side benefit of being able to buy shares in the company you work for at a lower price than that at which they trade on the open market. 

When deciding if and how many options you wish to accept as part of your compensation package, evaluate areas such as the company's business model, overall market share, strength of the management team, and competitive position. Often it is not the number of options that is in question, but their value. Having a 1% stake in an established, growing and profitable organization can be much more lucrative than having 40% of a higher-risk startup. 

If the company is already public, it is easier to gauge the value of the shares on the open market. Keep in mind that it's almost impossible to know what your options will be worth by the time they vest, as this will be a function of the company's performance, as well as future fluctuations and the liquidity of the underlying stock. Still, options are valued and traded daily, which can give one an idea of their worth. (Note: this refers mostly to publicly traded options, which exist only for a small cross section of pubcos-private equity options don't trade).

For private companies, it is more difficult to predict how their stock will fare after their initial public offering (IPO). Some important indicators include the development stage of the company, their level of financing - current and historical - and how close (or, given market conditions, how likely) they are to going public. 

Although a lot of people equate a company's IPO with instant riches, thousands of Silicon Valley "ex" paper-millionaires will tell you otherwise. As their companies' shares prices evaporated over the past year, so too did the value of their options. Also of note over the last year, many companies' shares have lost a significant portion of their value within the first few months of trading. As well, it is common practice for employers to stipulate a "lock up" period of 180 days after the IPO, whereby employees may be prohibited from selling their shares in the company. This reduces the risk of employees, key management, and controlling shareholders in attempting to sell their stock at once. Ensure you know what, if any, policies apply if the company is taken over. In the event your company is acquired, your options should transfer to the new firm at an accelerated vesting rate, or you may not get full value for them. 

Most importantly, your decision to accept options in lieu of salary should always be based on your lifestyle and individual circumstances, as well as your risk threshold, and investment and compensation objectives. The potential upside of options and the market valuation of the underlying stock are based not only on a company's potential, and performance, but also on stock market fluctuations and general economic conditions. However, if you depend on a steady income and can't afford the risk of your options expiring worthless, this may not be for you. The bottom line: you need to understand the real value of your company's option package, and, if possible, consult your lawyer or accountant, to make a responsible, informed decision.

Andrew Lindsay is Director, Brand Mandrake. His portfolio includes all activities related to culture, including acquisition and retention strategies for the incredible talent pool at Mandrake. Previously, he was founding Editor of "Investment World" magazine, profiling emerging small caps in Canada's junior equity markets. 


We welcome your feedback on these articles.  Please e-mail us at pointofview@mandrake.ca .

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