How Do Stock Options Affect a Company?

Overview of Stock Options

Stock options give a holder an opportunity to purchase shares in a company at a specified price over a specified period of time. The most common type of stock options are employee stock options, which companies grant as a form of non-cash compensation. The price at which the shares can be purchased is referred to as the options' strike price and is usually set at the shares' market price at the time the options are issued. If the company's shares rise in value, the option holder will be able to exercise his options at the specified strike price and earn a profit. If the shares decline in value, the holder's options will be worthless, but he will not incur any monetary loss. Stock options have been issued with increasing frequency in recent years and are currently given to senior executives, lower level employees, and in some cases to customers and suppliers for services rendered.

Qualitative Impact of Stock Options on the Issuing Company

From a qualitative perspective, stock options provide a benefit to the issuing company by helping to align employee incentives with the incentives of company shareholders. By making employees shareholders of the company, options help ensure that employees will be motivated to maximize shareholder value. Stock options also give employees an incentive to remain with a company over a long period of time in order to profit from the financial growth of the business. Additionally, stock options give companies a way of attracting top talent without having to pay large cash salaries or bonuses. For this reason, options are particularly appealing to companies that are not profitable and cannot afford to pay large salaries.

Quantitative Impact of Stock Options on the Issuing Company

Current accounting rules require U.S. companies to expense stock options when they are issued. Consequently, although stock options do not result in a cash outflow for the company, they do create an expense on the company's income statement, which lowers earnings. Although accounting rules do not specify a particular method for computing the cost of an option, any method must fulfill three criteria: 1) the method must be applied in a manner consistent with fair value measurement objectives, 2) the method must be based on established financial economic theory that is generally applied in the field, and 3) the method must incorporate and specify all assumptions regarding the future performance of the company's stock. Additionally, the exercise of stock options creates additional shares outstanding, which dilute existing shareholders and can lower a company's earnings per share. When an option is exercised, the option holder effectively purchases newly issued shares in the company. Suppose you own 50 shares in a company with 100 total shares outstanding, giving you a 50% ownership stake in the company. Now suppose that the company issues 100 stock options, which are immediately exercised. Total shares outstanding now equal 200, and your ownership stake has been reduced to 25%. This type of dilution often upsets a company's existing shareholders if management issues an excessive number of stock options.

Resources

• MyStockOptions.Com