Employee stock options, in theory, align the interests of the people running and working for a company with the interests of the shareholders. If a company performs well, the it becomes more valuable. That increased company value should be reflected in the price of the company stock, sooner or later.
Awarding options is a way to motivate employees and managment to work extra hard to make a company profitable. More profit=higher stock price=higher option value. On the surface, this makes sense. Work hard, perform, deliver results, reap rewards. Everyone wins!
So how does it work?
Let's say, for example that I work for Giggle (the purely fictitious Internet search company), and two years ago and I was awarded 10,000 stock options at the price of $120 per share. I don't actually buy the shares; I have an option to buy them at a set price, within a specified time period. Using a complex Giggle algorithm, it quickly becomes obvious to me that every dollar increase in the price of the stock puts $10,000 in my pocket. If the stock goes down in price, I lose nothing. Overall, there is no risk for me.
So two years go by, during which I have worked many hours and helped Giggle to dominate the Internet advertising space. All this accelerating ad revenue has caused the stock price to skyrocket to $420, so I decide to exercise my option. I buy 10,000 shares at $120 per share and simultaneously sell those 10,000 shares at $420 per share. My net profit is $3 million, less transaction fees and taxes. Yee-ha!
So where does that $3 million come from?
Good question.
To give someone something, it is usually necessary that you own it. Therefore, the company, Giggle in this case, needs to actually own some of it's own stock to sell to me. If they don't own stock, they would have to buy some at the market rate.
Option 1:
Already own the stock.
Giggle takes shares that it could sell on the open market for $4.2 million and sells it to me for $1.2 million. Net result is that I am $3 million richer and the company is $3 million poorer.
Option 2:
Have to buy stock.
Giggle buys stock for $4.2 million and sells it to me for $1.2 million. Net result is that I am $3 million richer and the company is $3 million poorer.
Now $3 million may sound like a lot of money, but Giggle has 300 million shares outstanding, so it is really only about a penny per share. Small price to pay for all that increased motivation and performance. But wait a minute, you may ask. What if Giggle has 1,000 employees, each with 10,000 options. That works out to $3 billion in payouts. That seems a bit excessive, doesn't it?
Well, the shareholders are in luck. There is a highly qualified Board of Directors looking out for the shareholders interests! The Board would never stand for excessive spending on stock options. They say "Options are good. Besides, our competitors are doing it so if we don't join in, all our good managers might go work for Mister Softey or Yoyo". For doing such a good job of looking out for the shareholders, the company issues more options to the directors, which the directors then duly approve.
It turns out that most of the shareholders are mutual funds and institutions. Many individuals own the stock in retirement and investment accounts. They trust the fund managers to look out for their best interests. The mutual funds also have Boards of Directors (affectionately known as "lap dogs") that are diligently looking out for the interests of the individual mutual fund holders.
In a perfect world, the amount a company spends on stock options would be more than offset by increased productivity and performance due to highly motivated employees and company management. When options get out of hand, and greed takes over, it is the shareholders that ultimately pay the price.
Awarding options is a way to motivate employees and managment to work extra hard to make a company profitable. More profit=higher stock price=higher option value. On the surface, this makes sense. Work hard, perform, deliver results, reap rewards. Everyone wins!
So how does it work?
Let's say, for example that I work for Giggle (the purely fictitious Internet search company), and two years ago and I was awarded 10,000 stock options at the price of $120 per share. I don't actually buy the shares; I have an option to buy them at a set price, within a specified time period. Using a complex Giggle algorithm, it quickly becomes obvious to me that every dollar increase in the price of the stock puts $10,000 in my pocket. If the stock goes down in price, I lose nothing. Overall, there is no risk for me.
So two years go by, during which I have worked many hours and helped Giggle to dominate the Internet advertising space. All this accelerating ad revenue has caused the stock price to skyrocket to $420, so I decide to exercise my option. I buy 10,000 shares at $120 per share and simultaneously sell those 10,000 shares at $420 per share. My net profit is $3 million, less transaction fees and taxes. Yee-ha!
So where does that $3 million come from?
Good question.
To give someone something, it is usually necessary that you own it. Therefore, the company, Giggle in this case, needs to actually own some of it's own stock to sell to me. If they don't own stock, they would have to buy some at the market rate.
Option 1:
Already own the stock.
Giggle takes shares that it could sell on the open market for $4.2 million and sells it to me for $1.2 million. Net result is that I am $3 million richer and the company is $3 million poorer.
Option 2:
Have to buy stock.
Giggle buys stock for $4.2 million and sells it to me for $1.2 million. Net result is that I am $3 million richer and the company is $3 million poorer.
Now $3 million may sound like a lot of money, but Giggle has 300 million shares outstanding, so it is really only about a penny per share. Small price to pay for all that increased motivation and performance. But wait a minute, you may ask. What if Giggle has 1,000 employees, each with 10,000 options. That works out to $3 billion in payouts. That seems a bit excessive, doesn't it?
Well, the shareholders are in luck. There is a highly qualified Board of Directors looking out for the shareholders interests! The Board would never stand for excessive spending on stock options. They say "Options are good. Besides, our competitors are doing it so if we don't join in, all our good managers might go work for Mister Softey or Yoyo". For doing such a good job of looking out for the shareholders, the company issues more options to the directors, which the directors then duly approve.
It turns out that most of the shareholders are mutual funds and institutions. Many individuals own the stock in retirement and investment accounts. They trust the fund managers to look out for their best interests. The mutual funds also have Boards of Directors (affectionately known as "lap dogs") that are diligently looking out for the interests of the individual mutual fund holders.
In a perfect world, the amount a company spends on stock options would be more than offset by increased productivity and performance due to highly motivated employees and company management. When options get out of hand, and greed takes over, it is the shareholders that ultimately pay the price.
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