Some companies find it advantageous to offer part of the compensation to their executives or workers in the form of stock options.
But what are stock options, in this context?
This type of compensatory stock option is basically what’s known as a “call option.” A call option is the right to purchase a certain amount of stock at a certain price within a certain time frame. The reason a call option can be valuable is that in effect you can wait to see the future before deciding to make the purchase. Like if you had an option to bet on “Lulabelle” in the 5th at Pimlico, and you were allowed to wait until halfway through the race before you had to decide whether to do so or not.
So what happens with a call option is if the market price of the stock is above the price set in the option contract (the “strike” price), then there’s reason to exercise the option, and if it isn’t, then you just let the option expire. For example, if your call option is that you’re allowed to buy 100 shares of a certain stock at $20 a share on August 1, and it turns out on August 1 the stock in fact is worth $30 a share, you’d want to exercise the option since you can buy that stock for a lower price than it’s worth-$20 versus $30. Whereas if it were selling for $15 a share on August 1, you wouldn’t want to exercise your option to buy for $20. The option is basically worthless.
When a company offers stock options it works similarly.
So Dotcom Bubble Inc. says to its prospective hire, “In addition to such-and-such salary, and this pension plan, and this health insurance plan, etc., we’ll also compensate you by way of stock options.” Often the options are spread over time (called “vested”) instead of being granted in full up front. So let’s say Dotcom Bubble Inc.’s current stock price is $10 a share. Their stock option plan might be that for every six months you stay with the company up to five years, you get the option to buy another 200 shares of stock at $10 a share, regardless of what its price is at the time.
If you last a year and a half, then, you’ll have the option to buy up to 600 shares of Dotcom Bubble Inc. stock at $10 a share. Which does you no good at all if it’s selling for $8 a share at that time. (Though it doesn’t hurt you; you just don’t exercise the option.)
But if Dotcom Bubble Inc. has taken off like gangbusters and is now selling for $40 a share, you’ll happily cough up $6,000 to buy those 600 shares.
For awhile it was really only executive compensation packages that tended to include stock options, but over time it’s become more common for them to be offered as part of the compensation for normal employees.
So why would a company offer stock options? What are the advantages, from its standpoint?
Mainly it’s a matter of encouraging loyalty by tying the employee’s compensation to the success of the company. You’re giving your employee a stake in your company’s future.
If I’m hired by Dotcom Bubble Inc. and given stock options, I want the stock price of the company to improve so those options are worth as much as possible when it comes time to exercise them, which gives me an incentive to do whatever I can in my job to contribute to bringing about that result.
By vesting the benefit, it also provides an incentive to stick with the company. Imagine I’m the employee with the option to buy 600 shares at $10 each after a year and a half when they’re worth $40 each. I’m less likely to quit or to do things that might get me fired since I know that if I stick around I’ll get a shot at another 200 shares in six months, and another 200 shares six months after that, etc. If the price is $40 now, maybe it’ll be $50 or $100 then. But even given the possibility it will instead drop back down to $30 or $20, that’s still looking good to me since I can buy at $10.
Another advantage is that offering stock options can help an emerging company that doesn’t have a lot of capital to toss around at the moment. Maybe Dotcom Bubble Inc. crunches all the numbers, and makes the best projections it can, and multiplies by all the relevant probabilities, etc., and determines that really they’ll end up paying about the same if they offer Executive A a yearly salary of $200,000 with no stock options or a yearly salary of $160,000 with stock options, or if they offer Employee B $23 an hour with no stock options or $20 an hour with stock options. But it still might prefer going the stock options route because it means it doesn’t have to come up with as much cash immediately to compensate its people.
By offering stock options, a company in effect is paying its employees less now, but in exchange is agreeing to divvy up with them some of the profits if it does well. For some companies, and some employees, stock options are a good deal. For others, maybe not. It depends largely on how well you expect the company to do moving forward, and to what extent that can be affected by giving employees a stake in the company’s success.