What are stock options?

Takeaway: A stock option is not a grant of stock—it is a contractual right to buy stock later at a fixed price; its value comes from the difference (“spread”) between that fixed price and the higher value of the stock in the future.

Stock options are the most common form of equity compensation in startups. They are a contract, not actual ownership, giving the holder the right—but not the obligation—to purchase a set number of shares at a fixed price in the future.

Core components of a stock option

Each stock option grant is governed by a formal Stock Option Agreement and will specify:

  1. Number of Shares – The total number of shares you may purchase.

  2. Exercise Price (Strike Price) – The fixed price per share you pay when you exercise the option. For startups, this is set by the board at the grant date’s fair market value, typically supported by an independent 409A valuation.

  3. Vesting Schedule – The timeline over which you earn the right to exercise your options. A common schedule for employees is four years with a one-year cliff.

  4. Expiration Date – The deadline to exercise your vested options, typically 10 years from the grant date (shorter if you leave the company).

How value is created: the spread

The economic upside of a stock option is the spread—the gap between your exercise price and the stock’s fair market value when you sell.

Example:

  • Grant: 10,000 options at a $1.00 exercise price.

  • After four years, the stock’s fair market value is $20.00.

  • Exercising costs $10,000 (10,000 × $1.00).

  • Those shares are now worth $200,000 (10,000 × $20.00).

  • The $190,000 difference is your spread—the value you helped create by contributing to the company’s growth.

Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.