Stock Option Definition

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stock option – n : the right to purchase a company’s stock in the future; an option is a legal offer or contract, typically granted by a company to an employee, director, or advisor, under which the grantee (holder of the option) has the ability to purchase a certain number of shares of the company’s stock for a stipulated price (the strike price). Most options are subject to a vesting period or vesting schedule, under which the grantee’s rights to purchase the stock in question vests over a period of time (continued tenure with the company); some vesting schedules, particularly those for corporate officers’ options, are based on accomplishment of specific milestones instead of, or in combination with, tenure. The purpose of a stock option is to provide a financial incentive (other than cash salary and/or bonus) to an individual whose contribution is considered important to the company’s ongoing success. This incentive works in two ways: a) the vesting schedule (typically between three and five years) encourages the option recipient to stay with the company until his/her option fully vests (thereby giving him/her the right to exercise the option, or purchase the stock, at the given strike price; and, b) the option recipient has extra incentive to help make the company succeed, and to see that success reflect in an increased stock price, since the individual’s strike price “locks in” his/her right to purchase stock at a (hopefully much lower) price set at the time the stock option was granted.

Example: ABC Corp. grants “Employee Smith” a stock option on January 1, 2006 for 36,000 shares of stock, at a strike price of $1.00/share, with a vesting schedule of 3 years vesting monthly in a straight-line fashion. Therefore, starting February 1, 2006 and each month thereafter for 36 months, Employee Smith vests on (earns the right to exercise) an additional 1/36th of her total options, of an additional 1,000 shares per month. At the end of the 3-year vesting schedule, her full 36,000-share option is fully vested (i.e., she has the right to purchase all 36,000 shares at $1.00 per share.