Option Exercise
Options exercise refers to the process where an optionee implements the right to buy the employer company's stock at the fixed price (exercise price) specified in the option contract. As a recap, options are granted to an employee. Upon grant, the optionee has the right but not the obligation to pay a fixed price for company stock over some period of time. When the employee pays for the stock, he exercises his options. His option contract "goes away" and he now holds shares of common stock in the company. These shares have some value. When he sells his shares he can receive cash in exchange for those shares. However, because private company stock is often illiquid, meaning that there is no easy way to buy and sell shares of private companies, receiving cash in exchange for stock must often wait for the company to have a liquidity event.
Vesting is a related but separate concept. Vesting refers to the number of shares of stock that the employee is eligible to purchase. This number increases the longer the employee is with the company.
Knowing if and When to Exercise
Knowing if and when to exercise can be difficult since the price at which you convert can and often is different than the price at which you sell your options. Your option contract will specify the price at which you can buy your shares. So for example, if you had an option contract with ABC Company that provided you the right to buy 1,000 shares at $1.00 per share, you would have the right to buy 1,000 shares for $1,000. When you exercise this right, you become the proud owner of 1,000 shares of ABC Company. Now just like a public company in the stock market, if the shares of ABC Company rise in value, you could make a lot of money when you sell your shares. For example, if ABC's shares reach a price of $10, your shares would be worth $9,000 upon selling. So the total profit to you would be $10,000 less the exercise price of $1,000 or $9,000. This is a good outcome for you. However, it is possible that ABC's share price could decrease. Assume that it decreased to $0.50. If that happened your 1,000 shares would be worth $500 upon selling. Your total profit in this case would be $500 less the exercise price of $1,000 or ($500). This is obviously not a good outcome.
Just as it is hard to predict stock market outcomes, it can be hard to predict private company outcomes. Private companies have the added challenge of being illiquid. This means that there is no market where willing buyers and willing sellers regularly buy and sell the private company's stock. Since markets usually establish prices, establishing the price of illiquid stock can be difficult, heavily driven by assumptions, and fraught with uncertainties. All of this means that you may not be sure of the actual value of your shares of private comapny stock.
There are several signs that indicate that a company is doing well and you might be wise to hold on to your stock:
- Is the company growing revenues? The faster the better.
- Is the company profitable or close to profitability?
- Does the company seem to have little problem raising money?
- Has the company had frequent acquisition offers or is it planning on going public?
Expiration
If a person fails to exercise his options, the contract and any rights associated with it will eventually expire.