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Underwater Options?
By Kimberly Clouse
With the recent NASDAQ volatility, more and more dot.com
employees--who used to believe that earning internet millions
was a given--are complaining that their options are "underwater."
What does this mean? Should we throw them a life jacket? Not
yet. Simply stated, it means that their options are worthless--at
least at today's stock price.
Consider this example: Let's say you recently joined Acme.com
and, as part of your compensation package, were given options
to purchase 10,000 shares of stock. The price at which you
are able to buy the shares of stock, known as the "exercise"
or "strike" price, is $50 per share. (For publicly traded
companies, the strike price is usually the stock's market
price on the day of the option grant, or in some cases, may
be at a discount to that price. For private companies, the
strike price is often based upon the company's valuation following
the most recent financing round.)
Under the terms of your option agreement, your options will
vest over a four-year period, and therefore you are not able
to realize immediate value from them. The vesting period refers
to the time period during which you earn the right to purchase
the shares and is part of the company's efforts to retain
employees. A typical vesting period consists of a one-year
"cliff" at which time 25% of the total options become available,
with monthly vesting thereafter. In our example, at your one-year
employment anniversary, 2,500 of your options would be vested;
from that point forward, 208 options would vest each month
(7,500 options divided by the 36 remaining months of the four-year
term).
Now assume that you've just celebrated your one-year anniversary
at Acme.com. You've vested 25%, and you are ready to exercise
your options. If the stock price were $75, you would have
won--your options allow you to buy 2,500 shares of Acme.com
at $50, and you can immediately sell them in the market at
a $25 profit (pre-tax profit). However, let's say the stock
price has recently fallen to $30. Your options are now "underwater"
and worthless. You have earned the right to buy a share of
stock for $50, when you could buy an equivalent share in the
market at just $30. Get the life jackets ready but don't panic
yet.
No one is forcing you to exercise your options at this point
in time, and the value might jump beyond $50 in the upcoming
months. What's important to realize is that options give you
an opportunity to participate in the future anticipated success
of a company--but, as with anything market-related, nothing
is guaranteed. To work for options is like making a wager.
Your options could have significant value before they have
vested but become worthless as soon as you are in a position
to exercise.
While it is impossible to ascertain the future value of your
company stock, one thing is true: the lower the strike price
of your options, the more likely it is that your options will
have value and that you will therefore realize a profit. Also,
keep in mind the importance of the vesting schedule. A long
vesting schedule could render your options worthless if you
don't keep your job for a substantial period of time. And
finally, as with all complicated financial matters, seek the
advice of a qualified attorney and accountant when negotiating
the terms of your options package.
This column is designed to provide accurate and authoritative
information on the subject of personal finances. It is provided with the understanding
that the Author is not engaged in rendering legal, accounting, or other professional
services by publishing this column. As each individual situation is unique,
questions relevant to personal finances and specific to the individual should
be addressed to an appropriate professional to ensure that the situation has
been evaluated carefully and appropriately. The Author specifically disclaims
any liability, loss or risk which is incurred as a consequence, directly or
indirectly, of the use and application of any of the contents of this work.
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