What are Employee Stock Options?

The use of options is very common in business, as they allow the parties to the contract to create today a right that can be materialized in the future usually within a pre-defined time frame.

In Employee Stock Options, the Option’s underlying asset is a Company Stock, the Parties to the Options Contract are an employer and employee, and the Option itself is part of a payment Package. Obviously, the option is always only about buying the underlying asset – Company’s Stock.

The basic rationale for using an Employee Stock Option is either to reward an employee with an asset that isn’t coming out of operational cash flow like direct pay does or to incentivize employees to conduct themselves in a manner that will enhance the price of the company’s stock, at least in the short term.

Use of Employee Stock Options is very common in public high-tech companies especially those involved in high competition between the brightest minds.

From an Employee’s point of view they make a lot of sense – there is unlimited upside with simply nothing to lose.

But do Employee Stock Options REALLY incentivize employees, and do they really get employees to think and behave as owners?

Some research claims that while Employee Stock Options do generate improved performance, the reason for it isn’t because the Employees considers themselves owner, but rather because they are thankful for a present, the present being the new wealth gotten if the option generated wealth.

It seems that in the main while Employee Stock Options are a valuable tool, they fail to transform employees into owners, a key factor and component in making a truly superlative company.

Example

Bob works as a sales manager for American Pie Company, which sells – well, pies.

American Pie Company is a public company whose shares trade for $2 per share.

Granny, the Chairman of the board and company’s CEO, wants to incentivize Bob to increase Sales, which will increase profitability and hopefully share price along with it. To do so, Granny authorizes American Pie Company to Grant Bob the right, but not the obligation to buy from American Pie company 100,000 stocks for $2 over a three-year period.

Granny’s logic is simple: Holding the options, Bob will start to think of himself as an owner and that will incentivize him to work harder. Holding the Options, Bob’s wealth becomes connected to the success of American Pie company.

How? The more sales Bob pulls in, the higher the profits, assuming all else is equal. The higher the profits, the higher the share price. The higher the share price, Bob can hold additional wealth by the difference between the price of the Option and the current share price.

For example, at $3 price per share, Bob generates an additional one dollar on each stock, which means he earned an additional $100,000.

In addition, the new wealth is taxed as capital gains, which is usually lower than the tax on an income.

Best of all, says Granny, the additional money (compensation) Bob might get does not come out of the company’s cash flow from business but appears magically out of thin air.

If Bob isn’t performing well, he does not get the extra wealth.

 

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