Stock Options: History, Advantages, and Disadvantages

Introduction

The phenomenon of stock options experienced a dramatic rise and fall over approximately fifteen years. They have been hailed as a great way to share ownership, attract and retain employees in a tight labor market, and "the fuel of entrepreneurial fire" (Malone, 2003). At the same time, they have been condemned as a major cause of the high-profile business scandals of 2000–01 and the subsequent downturn in U.S. stock markets — led by some of the biggest bankruptcies in U.S. history, at Enron and WorldCom. This paper describes what stock options really are, examines their history, weighs their advantages and disadvantages, and discusses their future in the business world.

What Are Stock Options?

A stock option is a contract offered by an employer that gives an employee the right to buy or sell a certain number of shares in the company at a specific price within a certain period of time. The price at which the option is provided is called the "grant" or "strike" price and is usually the market price at the time the options are granted. The employee holding the stock option is free to exercise it at his or her discretion; buying and selling the stock is not binding. ("Employee Stock Options Fact Sheet," NCEO Website)

As an example, a company may give an employee the option of buying a specific number of shares at the current market price (say $10) on a specific date. The stock option contract would have a "vesting period" — say, one year — after which the employee has the option of selling the stock at the then-current market price. If the market price of the share has risen to $15 after the vesting period, the employee can make a profit of $5 per share by buying at the strike price ($10) and selling at the market price ($15). The stock option also carries an expiration date, after which the employee's right to buy or sell the stock ends. If the share price falls — or remains the same — compared to the strike price before the expiration date, the option is worthless to the employee. However, the employee does not suffer an actual financial loss in any case.

History of Stock Options

Stock options first began to appear in U.S. businesses in the 1950s, but at that time they were generally modest in size. The trend of offering stock options — particularly to top managers — began to accelerate in the late 1980s. By the turn of the century, the typical CEO of a financial sector firm was receiving stock options worth $55 million a year, more than thirty times his salary (Shapiro, 2002). The practice became more widespread, and the National Center for Employee Ownership (NCEO) estimated that as of 2001, up to 10 million employees were receiving stock options in the United States.

Advantages of Stock Options

Stock options are considered an effective tool for aligning the interests of employees with those of shareholders. Since a rise in share price directly benefits employees holding options, they serve as a powerful motivator to work hard and add value to the company. Stock options are particularly well suited to promising new high-technology companies that need to attract technical and managerial talent without incurring a heavy payroll burden, as new recruits may accept lower salaries when offered options in exchange.

Another attraction of stock options, from the employee's point of view, is that only capital gains tax applies to profits made from stock options. If the same amount were received as salary, employees would pay normal payroll taxes — nearly twice as high. ("Employee Stock Options Fact Sheet," 2002; Shapiro, 2002)