Explaining Stock Options with a Couch
ISOs, ICOs, IPOs... all the financial TLAs (Three Letter Acronyms) get confusing to anyone who has not worked in finance or done trading. I know I didn't understand.
I'm here to try to explain the main concepts with a couch. Specifically my friend's couch. I'll phone my friend, Xavier:
Me: Hey, Xavier! Heard you're gettin' a new couch, could I have your old one? Xavier: Sure, ten bucks and it's yours. Come over anytime after Friday. Me: Thanks X!
Now, I don't have a couch. I have the option to get a couch. That option has a price: $10 ("strike price" in stock speak). And Xavier isn't a couch store; my option has a limit: 1 couch. I also can't just get the couch whenever I want; I must wait until after Friday to get the couch ("vesting" schedule in stock speak).
So on Saturday, I drive over to Xavier's with $10 in hand and get the couch (in stock speak, "exercise"; and moving couches definitely counts as exercise 😅). Now the couch is probably worth more than $10. If I didn't want the couch, just some cash from selling, I could bring someone willing to pay $100; once we get there, they pay Xavier the $10 I owe and pay me the remaining $90, instant cash!
Do not forget the government has a word for "instant cash": income. And they will be taxing me accordingly. There are ways to lower those taxes. Generally buying the couch early and waiting a long time before selling may subject me to capital gains taxes instead of normal income taxes, which are lower. But there's also a lot of particulars over the specific type of options I have (incentivized or not), what the price is when I get it vs when I sell it vs the actual price I paid, when all those things happened, etc. Probably best to ask a Tax expert or Accountant who can run the numbers in your particular case instead of a random article online talking about couches...
But let's go back to the exercise of getting the couch. What if the couch is actually worth $5? Nothing says I have to buy Xavier's couch. He may be a nice guy, but I'll go get the same couch for half price. Unless Xavier put an expiration date on my option, I can always come back for the agreed $10 if these couches suddenly become collectors items and sell for $500 a piece.
And that's it. Substitute "couch" with "stock" to get an explanation of stock options.
- Couch: It's... a couch
- Couch option: Not a couch; just an offer to buy a couch at a certain price (regardless of the actual value of said couch)
- Vesting: The predetermined time in the future when the couch can be purchased (after Friday in my story)
- Exercising: Buying said Couch offered in the Couch option (aka turning that Couch option into an actual Couch)
- Strike price: The price to buy the Couch from the Couch option ($10 in my story)
- Fair Market Value (FMV): How much the Couch is currently actually worth to other people ($100 in my story)
Couches aren't a good investment strategy. Neither are stock options or equity in a start-up.
It may be possible your options turn in to thousands or millions just like it may be possible the couch you got off your friend turns into a collectors' item. Enjoy it when it happens; Don't depend on it. Don't listen to the person who won the lottery telling you to invest all your cash in lotto tickets. Don't accept equity in return for lower pay and benefits.
You probably are not sitting on a nest egg. You are probably just sitting on a dirty old couch.