Problems with the Use of Stock Options as an Incentive
To attract top talent without straining the payroll, many public companies include incentive stock options (ISOs) in employee (primarily executive and management) compensation packages. ISOs also confer special tax benefits for the recipient, meaning that any profits made from exercising the call option are taxed at the lower long-term capital gains rate. However, ISOs can pose significant problems, both for the company and its employees.
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Market Downturn
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ISOs are "call" options, meaning that they confer the holder the right (but not the obligation) to purchase a certain number of shares for a given price (the strike price) regardless of current market price. If the current market price is higher than the strike price, the holder can buy shares from his company at the strike price and sell them in the open market for an instant profit. However, as long as the current market price is at or below the strike price, ISOs are temporarily worthless. Such situations can be very damaging to employee morale.
Shareholder Issues
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With the employee tax benefits of ISOs come onerous paperwork and administrative overhead. In order to issue an ISO package that targets a specific employee, such as a chief executive officer, a company must first submit a detailed written plan document specifying how many total shares will be offered, when the employee will receive them and whether this package will become standard compensation for the position. In the United States, it is required that all equity compensation (e.g. issuing shares through ISOs) packages be ratified by company shareholders. Alternately, salary, cash bonuses, golden parachutes and other non-equity forms of compensation can be decided by the company's board of directors without shareholder input.
If the shareholders vote down a proposed ISO offering, the company must draft a new plan. However, with each subsequent plan, there is a greater and greater chance that the target employee may take a position at a different company.
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Exercise Restrictions
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The rules for exercising an ISO can be somewhat limiting. For example, an employee cannot buy more than $100,000 worth of stock (via the ISO) in a single calendar year. Otherwise, the profits forfeit their ISO tax benefits. Furthermore, ISOs cannot be sold or transferred to non-employees (unless through death) and must be exercised within three months of leaving the company.
Dilution of Ownership
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When an ISO is exercised, the company has two choices: issue new shares or purchase existing shares from the open market. By issuing new shares, the company is increasing the total number of shares outstanding. This in turn has a negative impact on key financial ratios like earnings per share (EPS), which can lead to a lower market price.
Cash Outflow
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If the company decides to purchase existing shares at current market price, then they sell these shares to the employee at a loss (i.e. market price minus strike price). This loss takes cash from the company's treasury.
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References
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