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.