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 as owners do.
But do Employee Stock Options really succeed in achieving their stated goals for the business owners?
Here is what you need to know:
Employee Stock Options that do not end in sufficiently large stock holding by Employees and priced very close to the markets’ prices, are almost identically to cash payments. There is nothing wrong with these, but most likely they don’t turn the employee into a concerned owner and are experienced more like a cash bonus.
An employee getting Employee Stock Options find themselves in a – “No downside – All upside” Scenario. This means that the employee is not penalized for poor or negligent or damaging behavior, unlike an owner who is incentivized to act properly by both reward and penalty.
Employee Stock Options cause dilution and in so doing are either reducing the returns of the owners or if corrected via buyback eventually do cost the company and end up being a very expensive form of payment.
Since most executives discuss the future performance without mentioning the dilution caused by Employee Stock Options, Investors get the wrong impression that they are buying a cheaper asset, when, in fact, they are buying these at a relatively high cost.
Let’s take a look at “American Pie Company” for example:
The Net income of American Pie Company was $1,000,000, and the total outstanding shares “American Pie Company” has is 50,000 shares.
The Earnings Per Share (EPS) is calculated by the net income divided by total outstanding shares, which is $20. When including the stock options American Pie Company has given to its employees, which is 50,000 stocks, the EPS drops to $10!
Note how the inclusion of stock grants to employees aggressively dilutes the owner’s asset.
The hallmarks of a great company that is run by a great team are:
a) sizable stock ownership by executives and employees,
b) that it is held for a long duration,
c) and is preferably purchased by the employees themselves on the market.
An example of this kind of company would be a Canadian Technology company whose CEO is fanatic about maintaining the number of issued stocks constant.
Let’s see how this looks in practice:
The number of issued stocks remains constant throughout the years while the cash flow per share from the business expands as a result.
Also, to incentivize the employees, he is giving them a cash bonus instead of employee options, and the employees have to purchase the company’s stocks on the market and hold them for at least 5 years.
Let’s see what this practice does to the price per share of the company:
Because there is no dilution of the outstanding stocks, the full 100% of the growth in cash flows is reflected in each and every stock, which pushes the price per share sky high and generates incredible returns for everybody: investors, employees, owners, etc.
When this is found in a business, you have found a major wealth generation machine that one day will turn a mere $10,000 investment into a One Million Dollar fortune.