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Can you explain stock options?

stock options

stock options

New York - Stock options are being included in standard compensation packages for more and more people. Stock options help align the interest of shareholders and employees and help companies attract and retain employees.

Stock options, in their most basic form, allow an employee to purchase a certain number of shares of stock at a set price and for a fixed period. If the company prospers and the stock price goes up, an employee is still allowed to purchase stock at the original option price which would be lower. This is referred to as an "in-the-money" stock option. Of course, if the price of the stock goes down, the option has no direct value because the employee could go out to the public market and buy the stock for less than the original fixed option price. This is referred to as an "out-of the-money" stock option.

Companies have major incentives to use stock options in lieu of cash salary to employees. Financial statements prepared in accordance with generally accepted accounting principles do not require companies to record compensation expense for options given. In simple terms, the transaction is treated as a capital transaction and not as an income generating transaction. However, the IRS actually allows companies to deduct the expense from taxable income. The result is that companies report higher income for financial statement purposes and lower income for tax purposes.

There are several issues that companies face when issuing stock options. The biggest is that as employees exercise stock options and sell the stock, there is dilution of ownership and downward price pressure that effects other shareholders. Thus, corporations generally buy-back shares on the open market at a higher price. The result is that corporations use excess cash to compensate employees just as they would if they originally paid them higher salaries.


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