One of the ways that a company may choose to compensate its employees is through what are called “stock options.”
Employee stock options are a form of “call option.” They give the employee the right to purchase company stock later at the price it is today. Thus the stock option has value if the stock price goes up, and no value if the stock price goes down or stays the same (since in that case the employee could simply buy stock in the normal market at the same or better price than he would get by exercising the option).
Generally stock options are tied to conditions, most often duration of employment. So if the price of company stock is, say, $20 a share when the employee is hired, an employee stock option plan might specify that the employee will receive the option to purchase 50 shares of company stock at $20 a share after each six months of continuous employment, up to the first three years.
The term for these conditions is “vesting.” In the above example, after three years the employee stock option plan is fully “vested.”
So what are the advantages to an employer of offering stock options as part of employee compensation?
* Employee incentive to make the company do well
Stock options give the employee incentive to see to it that the company succeeds. Options only have value if the stock price goes up. Furthermore, the degree of value they have is proportional to the degree the stock price goes up. The employee derives no benefit at all from the stock option if the stock price is equal or lower when it comes time to exercise her option compared to what it was when she was hired. She derives slight benefit if the price is slightly higher. She derives moderate benefit if the price is moderately higher, etc.
* Employee incentive to remain with the company
Vesting ties the employee to the company. If the stock options are doled out over time, then the employee does not receive the full potential value of his compensation package unless he remains with the company long enough for his stock option plan to be fully vested.
* Less immediate liquidity required
Employee stock options are a form of deferred compensation. For new companies or companies without a lot of readily available capital, it may be advantageous to pay people less in salary now, and be obligated to pay them more in benefits later if and only if the company is higher in value when that time comes.