Stock Options: The Compensation Tool That Turns Employees into Shareholders

Stock options represent one of the most effective compensation mechanisms in the modern business world. Originating in Silicon Valley during the 1990s, these options quickly became the preferred instrument for retaining talent in high-growth sectors. But how do they actually work, and what implications do they have for those who hold them? Let’s unravel all the details.

What exactly are stock options?

Essentially, stock options are a right granted by the company to its employees to purchase shares of the company at a predetermined price, known as the strike. Unlike a contractual obligation, this is an option: the worker can choose to exercise it or let it expire.

The contract establishes four fundamental elements:

• A maximum number of available shares
• A fixed purchase price (strike)
• A validity period (generally between 3 to 5 years)
• The conditions of execution

Once the agreement is signed, the employee is free to buy all or part of the shares within the established period. If they decide not to do so, the option simply expires without financial consequences.

Stock Options in Startups and Tech Companies: Why Do They Work?

The reason why stock options proliferated first in the tech sector is not accidental. Tech companies have a unique scalability model: they can grow exponentially without the need for proportional physical investment. A startup can multiply its valuation in a few years, transforming stock options into potentially very profitable tools.

In contrast, traditional companies with slow growth models (retail, manufacturing) offer less attractiveness. That’s why the Startup Law in Spain has revived this mechanism as a tool to attract professionals in newly created companies.

From a business perspective, stock options offer clear advantages:

• They do not consume immediate liquidity
• They align the interests of the employee with the company’s growth
• They create a natural loyalty effect

How Stock Options Work: A Practical Example

To understand the mechanism, let’s imagine the following scenario:

Initial parameters:

• Volume: 1,000 shares
• Strike: €3 per share
• Term: 5 years

After three years, the company goes public and trades at €6 per share. The employee decides to exercise their stock options and pays €3,000 for shares that are worth €6,000 in the market, gaining an implicit profit of €3,000.

Here, the worker acts as an investor: buys cheaply (thanks to the strike) and sells at market price. The difference is their net profit before taxes.

Possible Scenarios: ITM, ATM, and OTM

The value of a stock option depends on the relationship between the strike and the current trading price:

In The Money (ITM): The strike is below the market price. If you have an option at €4.50 and the stock trades at €5.00, your potential gain is €0.50 per share. This is the ideal situation.

At The Money (ATM): The strike exactly matches the trading price. Theoretically, there is no profit or loss, although this is a rare scenario in practice.

Out of The Money (OTM): The strike exceeds the market price. If your option is at €8 and the stock is worth €6, it’s not worth exercising. The option expires worthless.

Stock Options vs. Share Options: Key Distinctions

Although they operate under the same mechanism, there are fundamental differences:

Stock Options: Exclusively for company employees. They do not require premium payment. They are compensation tools, not investment products.

Share Options: Any investor can buy them on the market. They do require premium payment (the cost of the right). They are traded on secondary markets.

Both are Call (right to buy), but access and financial structure differ significantly.

Benefits and Risks for the Employee

Positive aspects:

• Allow capturing unlimited gains without initial capital risk
• Create alignment between employee and company
• Function as a loyalty tool without reducing the company’s cash reserves

Negative aspects:

• Do not guarantee profitability: if the stock price falls, the option may expire worthless
• Gains are subject to taxation
• Can generate “golden handcuffs”: employees trapped waiting for expiration date

Taxation of Stock Options in Spain (2023)

Stock options are taxed as capital gains. The calculation is simple:

Initial Value (VI) = Strike = €3 Final Value (VF) = Sale price = €8 Capital gain = €5,000 (sobre 1,000 shares)

This capital gain is taxed according to the 2023 brackets:

• €0 to €6,000: 19%
• €6,000.01 to €50,000: 21%
• €50,000.01 to €200,000: 23%
• €200,000.01 to €300,000: 27%
• Over €300,000.01: 28%

Important: The brackets are tiered, not progressive. Of the €5,000 gain, all is taxed at 19%, resulting in €950 tax and €4,050 net.

Stock Options vs. Futures: Critical Differences

Although both are derivatives, their characteristics are different:

Futures are obligations: you must execute whether you want to or not, buying or selling the asset at a fixed date.

Stock options are rights: you decide whether to exercise. This is the essential difference that determines the risk/benefit profile of each instrument.

Types of Options in the Market

Call: Right to buy an asset at a specified price and date. Ideal if you expect the price to rise.

Put: Right to sell an asset at a specified price and date. Useful in bearish markets.

All stock options are Call (right to buy), but options on shares traded in markets can be both types.

Investment Strategies with Share Options

For those who want to invest (without working as employees), there are two approaches:

Bullish strategy: Buy Call options at a low strike, expecting the asset to rise. If it does, exercise and capture the difference.

Bearish strategy: Buy Put options at a high strike, expecting the asset to fall. At expiration, if the price is lower, sell at your higher strike and capture the difference.

Final Reflection

Stock options represent more than a compensation mechanism: they are an entry point to business growth for committed employees. Their operation is transparent, their potential benefits significant, but they also require a clear understanding of the risks.

Whether as an employee receiving stock options or as an investor interested in share options, the key is to understand when to exercise the right and when to let it expire. Timing and patience are as important as the mechanism itself.