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Stock Options
A stock option is a right given by a company to an employee to buy a specific number of shares of company stock during a specified time period at a set price, the exercise price, determined on the date of grant. In most cases, the exercise price is equal to the market stock price on the date the award is granted.
How do stock options work in the real world?
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Jane receives a grant of 200 shares with an exercise price of $20 each. She cannot exercise
her options for five years and by then the market price has increased to $40. Jane can exercise
her options and purchase 200 shares of stock at $20 apiece, then sell them for $40 apiece,
and keep the difference.
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Stock Option Pros and Cons
Pros
For employees:
- Reward for higher performance
- Wealth accumulation
- Ownership stake
- Increased motivation
For employers:
- Flexibility of stock option plans
- Save cash and offer employees a part of future success (particularly for small, growing companies)
- Cost of plan is "self-funded" through increased employee productivity and stock price gains
- Attract, retain, and motivate employees
For shareholders:
- Align management and employees with shareholders
- Employees take a greater interest in the factors driving business success
On the other hand, stock options have disadvantages too.
Cons
- High potential for shareholder stock dilution
- Become worthless if the market stock price drops below the exercise price and stays “underwater” until the grant expires
- Decline in stock value affects employee morale, and underwater shares lose their motivation and retention value
- Subject to volatile price movements
- Seen as a short-term compensation element; employees generally cash in soon after vesting not realizing the long-term potential appreciation of their shares
Memory Jogger
Beatrice receives an option of 1,000 shares with an exercise price of $20 each. The market price increases to $50. If Beatrice exercises her option and buys 1,000 shares at $20 each, and then sells them for $50 each, how much will she end up with (without tax implications)?