Listening to recent news, you'd think that stock options were the biggest scandal to rock the financial world since Enron. Companies from a wide range of industries, from Monster Worldwide (Nasdaq: MNST ) to Michaels Stores to Bed Bath & Beyond (Nasdaq: BBBY ) , have faced questions about their practice of granting options to top executives, including, in some cases, backdating those options grants to maximize their value. If you're not familiar with the way stock options generally work as a form of compensation, you may conclude that options should be eliminated entirely.
However, many rank-and-file employees receive stock options as part of their overall compensation package. For these employees, stock options don't represent a windfall; many companies use the lure of options to save money on other forms of compensation, including salaries and benefits. Used properly, stock options can help cash-poor companies hire and retain higher-quality employees. As an employee receiving stock options, however, you have to recognize the importance of understanding how your options work and actively managing them to get the most value from them.
How stock options work
In simple terms, the stock options a company's employees receive generally give them the right to purchase shares of their employer's stock at a certain price. With broad-based option plans in which a large group of employees receive options, the price that employees have to pay for the shares, also known as the strike price, is determined by the market price of the stock when they receive the options. As a result, when employees first receive options, they have little or no intrinsic value. Because employees could buy shares of their company through a broker for the same price, the options don't give them any special advantage over any other person interested in buying shares.
On a side note, with option plans offered only to executives, the strike price is often set below the current market price, to give executives an immediate benefit. This partially explains why the practice of backdating options has caused such a scandal -- by choosing advantageous dates to use for setting the prices, companies can give executives options that already have substantial intrinsic value.
Depending on the specific terms of the company's option plan, employees may have to work at the company for a set period of time before their options vest and become eligible for exercise. If employees leave the company before they've worked there for the specified period of time, they may have to forfeit their options and won't be able to exercise them, even if the options have become valuable since the time they were granted. Once employees have fulfilled the minimum work requirement, then they can exercise their options at any time. Although employee stock options expire, many options give employees several years before they have to exercise them.
Options reward employees for job performance that contributes to positive moves in their employer's stock price without giving them the risk of negative stock movements. The worst-case scenario for employees is that the value of their employer's stock will fall over time and leave their options to expire worthless. However, under no circumstances will they lose money from their options; nothing requires employees to exercise their options if it doesn't make economic sense to do so.
Benefits of stock options for employers
There are several reasons why employers prefer using stock options as a part of the compensation package they offer to employees. Perhaps the easiest one to understand is that from the company's perspective, stock options don't cost anything. Unlike other forms of compensation, which require the company to find the cash to pay its employees, stock options have no effect on a company's cash flow. In fact, when employees exercise their options, the money that employees have to pay as the strike price can lead to an inflow of cash for the company. Although stock options have the effect of diluting the company's earnings per share, many companies view this problem as of only secondary importance, especially during their initial stages of growth.
In addition, stock options ensure that employees are motivated to further the interests of the company's shareholders. With cash compensation, employees may have little incentive to give extraordinary work performance; bonuses and other cash incentives may not reflect the actual worth of a particular employee's contribution toward the company's success. With options, on the other hand, employees and shareholders all benefit from rising share prices.
And last, until recently, companies that used stock options as compensation didn't have to count the value of the granted options as an expense for accounting purposes. Therefore, to the extent that companies that used stock options were able to reduce their employees' salaries and other traditional compensation costs, they saw those cost reductions fall through to their bottom line when they reported quarterly earnings. Since last year, however, companies have had to treat grants of stock options as an expense against their earnings.
Stock options can give employees of successful companies a huge incentive to work hard toward building shareholder value. As with any other profit-making opportunity, the IRS wants its piece of the action. The second part of this article looks at the tax consequences of various types of stock options.
If you're wondering how to incorporate stock options you own into your financial plan, you may want to consider taking a closer look at the Fool's personal-finance service, Motley Fool Green Light. From investing advice to information on taxes and how to diversify your portfolio, Green Light has something for everyone. Take a look at the latest issue, along with past publications and other resources, for 30 days with no risk.
Bed Bath & Beyond is a Motley Fool Stock Advisor recommendation.
Fool contributor Dan Caplinger has never had the good fortune of getting stock options at work. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy doesn't backdate on you.