What are stock options? Stock options are contracts granted by a company to its employees where they are given an option to buy shares at some point in the future at a fixed price, which is known as the strike or exercise price. They're used by companies as a form of remuneration due to the fact that the employees will potentially be able to purchase company stock at a discount to the market price. Companies like rewarding their employees with stock options because it ultimately motivates the employees to improve the performance of the business, which in turn will increase the company's share price and therefore make the options more valuable to the employee. So a mutual benefit is received by both parties.

So now let's look at this example to understand the terminology frequently used in the context of stock options. It says, a company grants 500 options to employees with an exercise price of $2.50. The options best in three years, and the options are forfeited if employment ceases. So the company is offering its employees the ability to buy 500 options at a price of $2.50 each at some point in the future. So instead of paying the market price for the shares, they can purchase these at $2.50. This is known as the exercise or stripe price. We are told that the options vest in three years, so the options are granted today, but the employee cannot exercise their options until the three year vesting period has passed. This again is a great benefit for the company as it locks the employee to continue their employment for a minimum period of three years before they can receive the potential benefit from them. The last section explains this. If the employee were to leave their employment or be terminated, they would forfeit their ability to exercise their options. This is sometimes referred to as surrendering their rights to the options.

So to reiterate, we have the vesting period. This is the time from the grant date until the employee is able to exercise their options. And in our example, this is three years. And we have a vesting condition. This is a condition that must be satisfied in order for the employee to be able to exercise their options. In our example, this is a service-based condition. In other words, the employee must remain employed by the company to be able to exercise their options at the end of the vesting period. Vesting conditions stop the employees receiving their shares and then leaving straight away. This would not be favorable for the company. The diagram below shows the timeline of the company from year zero to the end of year four with the share price on the Y axis. At the end of year zero the 500 options are granted when the share price is at $1.50. At this point, the options cannot yet be exercised by the employees, as the options have not yet vested. But even if they could, they wouldn't do so. This is because the excise price of $2.50 is higher than the current market price. Where this is the case, the option is described as being out of the money. However, if we fast forward three years, then we reach the vesting date. At this point, the employees have satisfied the vesting conditions and now have the right to buy the shares. However, the options are still out of the money as the exercise price of $2.50 is still above the current share price. So instead, the employees will hold onto their options until year four when the share price has increased above the exercise price. And we can see this's reflected in the diagram. At this point, the options are in the money and the employees will decide to exercise their options and receive shares in the company at a purchase price of $2.50. This is referred to as the exercise date. So important to note, the employees do not need to exercise their options at the vesting date. This is only the date from when they can start exercising them. Another key point is that the options would typically have an expiration date. This is the date that the options must be exercised by.