Public companies — and private companies that plan to go public — use stock options as incentives for recruitment or retention of key employees and as rewards for performance. A stock option gives its holder the right to buy a share of the company’s stock at a set price after a certain amount of time known as the vesting period. Employees usually have 10 years to exercise their stock options. If the company’s stock price rises above the option's strike price, the employee may make a profit by exercising the option and selling the stock.
1. Verify that the options are vested. Employee stock options are usually granted with a defined vesting period. The employee may be required to remain with the company for two years, for example, before he can exercise the options. If the option’s vesting period has not been fulfilled, the employee may not exercise the options, and if he leaves the company, he will be forced to forfeit his unvested options.
2. Contact your employer’s brokerage firm and inform it that you want to exercise your options. You may also deliver the options to an external brokerage firm, although the process is easier to manage with a broker that is already working with your employer.
3. Buy shares of the company's stock at the option’s strike price. Each option gives you the right to buy a share of stock at the strike price, or original grant price, of the option. The strike price is set by management when the options are issued to the employee, and usually matches the stock's market value at that point in time. Companies may revalue options, changing the strike price to a lower value. This happens when the company's stock price falls below the options' exercise price. Management revalues options to retain their employees.
4. Instruct your broker to sell the shares of stock and take the profits on your purchase. Brokers may lend you money to buy the stock, and get repayment when they sell the stock for you on the open market. The IRS considers the proceeds from the stock sale as ordinary taxable income. If the current market price is below the options’ strike price, the options are considered to be "underwater" — worthless. Many employees choose to hold their vested options until the stock appreciates enough for them to make a good profit.
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