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Compensation: Incentive Plans: Stock Options

The "right" to purchase stock at a given price at some time in the future.

Stock Options come in two types:

How do Stock options work?

An option is created that specifies that the owner of the option may 'exercise' the 'right' to purchase a company's stock at a certain price (the 'grant' price) by a certain (expiration) date in the future. Usually the price of the option (the 'grant' price) is set to the market price of the stock at the time the option was sold. If the underlying stock increases in value, the option becomes more valuable. If the underlying stock decreases below the 'grant' price or stays the same in value as the 'grant' price, then the option becomes worthless.

They provide employees the right, but not the obligation, to purchase shares of their employer's stock at a certain price for a certain period of time. Options are usually granted at the current market price of the stock and last for up to 10 years. To encourage employees to stick around and help the company grow, options typically carry a four to five year vesting period, but each company sets its own parameters.

Advantages
Disadvantages
  • Allows a company to share ownership with the employees.
  • Used to align the interests of the employees with those of the company.
  • In a down market, because they quickly become valueless
  • Dilution of ownership
  • Overstatement of operating income

Nonqualified Stock Options

Grants the option to buy stock at a fixed price for a fixed exercise period; gains from grant to exercise taxed at income-tax rates

Advantages
Disadvantages
  • Aligns executive and shareholder interests.
  • Company receives tax deduction.
  • No charge to earnings.
  • Dilutes EPS
  • Executive investment is required
  • May incent short-term stock-price manipulation

Restricted Stock

Outright grant of shares to executives with restrictions to sale, transfer, or pledging; shares forfeited if executive terminates employment; value of shares as restrictions lapse taxed as ordinary income

Advantages
Disadvantages
  • Aligns executive and shareholder interests.
  • No executive investment required.
  • If stock appreciates after grant, company's tax deduction exceeds fixed charge to earnings.
  • Immediate dilution of EPS for total shares granted.
  • Fair-market value charged to earnings over restriction period.

Performance shares/units

Grants contingent shares of stock or a fixed cash value at beginning of performance period; executive earns a portion of grant as performance goals are hit

Advantages
Disadvantages
  • Aligns executives and shareholders if stock is used.
  • Performance oriented.
  • No executive investment required.
  • Company receives tax deduction at payout.
  • Charge to earnings, marked to market.
  • Difficulty in setting performance targets.

When do Stock options work best?

  1. Appropriate for small companies where future growth is expected.
  2. For publicly owned companies who want to offer some degree of company ownership to employees.

What are important considerations when implementing Stock Options?

  1. How much stock a company be willing to sell.
  2. Who will receive the options.
  3. How many options are available to be sold in the future.
  4. Is this a permanent part of the benefit plan or just an incentive.

Web links on Stock Options?