In this second installment of the revived Money Sunday series, you will learn about stock options: what they are, how they work, and why they are so controversial. Learn about this huge element of executive compensation so you can become a smarter, more politically savvy Kossack.
Whether you received stock options yourself — are you lucky? — or want to understand more about how top executives receive so much more pay than their own workers, read on. And take a look at past Monday Sunday articles linked below....
Defining Stock Options
Let's start with the easy part: stock. When you buy a stock usually you are buying an actual ownership share in a publicly traded company. (That's called common stock.) For example, General Motors has approximately 565.74 million shares of stock in circulation, so if you own one share of GM stock you literally own one 565,740,000th of the entire company. GM's CEO works for you, the shareholder! Companies sell stock in order to raise investment capital: to buy buildings, equipment, road signs, desks, and otherwise get their businesses going and growing.
An option is what it sounds like: it's a choice. In this case, you have the choice to buy the stock at a certain price. This price is called the strike price.
OK, so let's put it all together. Let's say that your employer, Company XYZ, grants/gives/awards you a stock option. This stock option allows you to purchase one share of XYZ at a certain strike price — $10, let's suppose. What is this stock option actually worth?
How Do Stock Options Work?
The value of a stock option depends on the current market trading price. For example, if you receive a stock option at $10, and the market price is $20, you should be very happy: on paper, at that instant, your stock option is worth $10, the difference between the market price and the strike price. That's because the stock option gives you the right to buy one share at $10 and then immediately sell it on the open market for $20, making an instant $10 profit, minus any broker sales commission. If you do this (buy the share at the strike price and sell it at the market price) you are exercising your stock option.
If the strike price is above current market trading price, your stock option is said to be underwater and is, at that instant, worthless. However, your stock option has the future potential to earn you money — if the stock price rises enough. And if the price rises high enough before the deadline.
Deadline? Yes, stock options typically expire, like cartons of milk. Also, if the common stock becomes worthless (due to the company's bankruptcy, for example), your stock option will also never have value. And there's another way you can lose potential stock option value: if you leave the company too early.
Leave too early? Yes, in most cases you will receive stock options with a vesting period. During the vesting period you must remain a loyal employee, and you cannot exercise your options even if the market price is sky high. Once your stock options vest, normally you can exercise them any time you wish (and if they are "above water" of course). Normally your stock options will vest immediately if your employer lays you off or fires you unless you are fired for "good cause," such as stealing from your employer.
Like anything else in finance, there are complications and permutations. For example, when you exercise your stock options you may be able to convert them to ordinary common stock instead of cash if you wish. That said, the above represents the basic ways stock options work.
Why Do Companies Award Stock Options?
The major reasons why companies award stock options are to encourage company loyalty (via the vesting period) and, particularly for top managers, to encourage the employee to work hard to boost the stock price for the company's owners, i.e. all stockholders. It's easy to see why stock options would encourage these behaviors, and they do. Stay loyal to the company and help the company perform well (in Wall Street terms), and you will receive more money.
In the past several years start-up technology companies have found stock options particularly valuable. If a start-up cannot afford to pay the first group of employees and managers high salaries, one way to "bootstrap" such a company is to pay with stock options. It's a bit like paying employees with lottery tickets, but some employees are willing to take the risk in exchange for the potential rewards. There are a lot of tech millionaires as a result of stock options, and there are a lot of poor ex-tech workers, too.
There's another reason, though: stock option awards may have certain tax and regulatory benefits. Let's suppose you receive stock options with a vesting period of two years. You wait two years, then you are lucky enough to exercise all the options to generate a cash profit. In that case you would pay ordinary income tax only on the cash profits, at the same marginal rate as your regular salary earnings for that year. Depending on your timing, you might have a lower tax rate. Better yet (for tax purposes), if you wait the two years, convert your stock options to ordinary shares, wait again, then sell the shares, you may be able to treat any profits (i.e. sale proceeds above the strike price) as long-term capital gains, subject to a lower tax rate. Consult your tax advisor for details.
Controversies and Criticisms
The tax implications are controversial enough, but there are other problems with stock options. Here are some of the biggest:
- Companies did not properly report stock options on their balance sheets as business expenses, misleading investors into thinking companies were more profitable than they actually were. U.S. GAAP (Generally Accepted Accounting Principles) are now requiring proper expensing of stock options.
- Companies played games with improperly dating stock option awards. Many companies award stock options based in some way on current public trading price. (The simplest way, of course, is to set the strike price the same as the public closing share price on the day the employee receives the stock option.) However, the SEC is investigating many companies that apparently backdated stock options, particularly those awarded to senior executives. That is, the companies awarded stock options, but they picked a prior trading date when the public share price was relatively low and marked the stock option as if it were awarded on that day. That's accounting fraud, quite simply, and people should (will?) go to jail.
- Companies award stock options, particularly to top management, with ridiculously low strike prices, undermining the options' incentive value. This problem is part of the wider criticism of executive pay as being too generous even when the company performs badly. If the strike price is $1 for a stock with a $100 market price, what's the point? The recipient could still make a fortune even if ordinary shareholders lose half their stock value!
- Stock options may encourage "bad" executive behavior. In particular, assuming Wall Street traders do not have perfect information about a company's internal affairs, executives with stock options may try to make the stock "pop," timing certain management decisions and announcements artificially in order to maximize the value of their stock options once they vest. These artificial efforts may actually damage the company's long term profitability. Again, this problem is part of the wider problem of executive compensation and of criticism of Wall Street for focusing too much on short-term results.
- Arguments about whether more or fewer employees should receive stock options, and under what terms. Personally I think all employees should receive stock options if that's what they prefer, but there should be a fair choice available. Note that unions can help employees negotiate the best compensation package, although unions tend to prefer outright stock grants in exchange for any wage concessions. I think unions probably view outright grants as easier to value and less susceptible to management manipulation. That said, I think unions should support any employee preference for stock options.
Your Turn, and More
That concludes today's Money Sunday. Be sure to read the comments, though, and add your own — Money Sunday Kossacks are some of the most astute personal financial planners. Past articles are also enlightening.
May 13, 2007: The Benefits of "Automatic" Retirement Funds
May 8, 2005: Is There a Housing "Bubble"?
April 24, 2005: Saving with Little or No Lifestyle Impact
April 17, 2005: Stocks Down (Again)
April 10, 2005: Enjoy Credit Card Rebates
April 3, 2005: Dealing with High Oil Prices
March 13, 2005: Declining Dollar, What to Do
As a reminder, Money Sunday is no substitute for professional financial advice, and the information presented here is for entertainment purposes only. So don't sue me, DailyKos, or anyone else if something doesn't work out for you, OK? Just be glad everyone around here is fighting for Social Security, since everyone deserves a guaranteed basic income even if the worst should happen.