Stock options have been called both the best and worst compensation tool ever devised. The truth can fall at the extremes or anywhere in between, depending on who receives options, why they are issued, and the details of how they are structured. To pass judgment on a single options program or individual grant, one must understand the “who,” “why,” and “how” of the options in question. Their appropriateness also depends on how closely the behavior of the recipients can be monitored and on the mechanisms available to halt counterproductive behavior (and to reinforce productive behavior). As experience has shown, the absence of stringent monitoring of options can be dangerous indeed for outside investors. In the worst case, senior executives with significant stock options may be motivated to manipulate stock price for their own gain. Any big stock options award has the potential to dilute all other investors, the actual providers of capital.
In simplified terms, when a company awards stock options to an individual, it gives that person the option, or right, to purchase a specified number of shares in the company at some specified time in the future. The price at which the recipient can purchase the stock is called the strike price, which is set at the time the option is granted and is usually the stock’s current price. Options holders profit when they can exercise their options and sell the resulting stock for more than the strike price. When options are granted to employees instead of stock, the ultimate value to the employee depends not on the value of a share, but on the increase in the value of a share, requiring growth—actually, growth in share price. The estimated value of the option reported in the proxy statement is not the value received, but only an estimate based on historical price performance and other factors.
Two control factors are the window of time during which the option can be exercised and turned into stock and the restrictions on when the recipient can sell the resulting stock. For example, the recipient might be allowed to exercise the option within a year but prevented from selling the stock for three or more years from the date the option was issued. In some instances companies will buy the option directly from the holder. When this happens, the holder never has to put up any cash to exercise the option. The exercise and sale are, in effect, simultaneous, which means that no shares are actually issued.