While nearly every investor has heard of stock options, few are likely aware of their close cousins, restricted shares and stock appreciation rights. Even if investors have heard of them, fewer still probably understand how they work.
You know stock options: They give the holder the right to buy a stock at some point in the future, hopefully when it's trading at a price much higher than when the options were granted. Options gained popularity as a form of non-salary compensation in the early 1990s, when a $1 million cap on executive pay was imposed. Just last year, SEC Chairman Christopher Cox said the salary cap "deserves pride of place in the Museum of Unintended Consequences."
Abuse of stock options has seemingly become rampant. Investigations have uncovered nearly 200 companies that engaged in backdating -- retroactively setting the price of an option at an earlier date and a much lower price. Backdating gives executives additional unearned profits, at shareholder expense. Not surprisingly, options are not nearly as popular a form of compensation as they once were.
A close but less-observed cousin of stock options, regularly used to compensate management, is restricted stock. The restriction is usually the amount of time that must elapse before the recipient gets the shares. An employee awarded restricted shares must do nothing more to receive them than remain employed for a set number of years. Microsoft
Restricted stock is considered a better form of compensation than stock options. With a stock option, the holder can choose to exercise the option once it vests, depending upon the price. A restricted share, on the other hand, is given to the holder on the vesting date, regardless of the price. Restricted stock encourages holders to take a vested interest in the well-being of the company, while options simply encourage holders to increase the stock price. American Eagle Outfitters
Both, however, are subject to abuse. In addition to backdating, stock options are subject to other tricks, including "repricing," which arbitrarily resets the price of the option to a lower cost. That usually happens when options are "underwater," or below the price at which they were initially granted. Repricing defeats the option's original purpose and rewards failure. Similarly, restricted shares can simply be cancelled if they are below the award price.
Investment banking firm First Albany
Stock appreciation rights
Stock appreciation rights are similar to options in some respects: They're granted at a set price, and once they vest, employees can exercise them at any time prior to their expiration. But employees don't have to pay a price to exercise them, as they would with options. They just get the difference between the grant price and the exercise price, which can be paid in cash, stock, or a combination of the two.
Foolish final thoughts
While stock options are not nearly as popular as they once were, don't expect them to disappear. In a raging bull market like we had a few years ago, options were very popular because of the chance to gain huge sums of money. In down or sideways markets, options are less of an incentive. That's why we're likely to see companies issue greater numbers of restricted shares and stock appreciation rights -- until the next bull market.
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