In the debate over whether or not options are a form of compensation, many use esoteric terms and concepts without providing helpful definitions are a historical perspective. This article will attempt to provide investors with key definitions and a historical perspective on the characteristics of options. To read about the debate over expensing, see The Controversy Over Option Expensing. Definitions Before we get to the stock, the bad and the ugly, we need to understand some key options. An option is defined as the right abilitybut not the obligation, to buy stock sell a stock. Companies award or "grant" options to their employees. These allow the employees the right to buy shares of the company at a set price also know as the "strike price" or "award price" within a certain span of time usually several years. The strike price is usually, but not always, set near the market price of the stock on the day the option is granted. The options are earned also referred to as "vested" over a period of time. Intrinsic Value or Fair Value Treatment? How to value options is not a new topic, but a decades-old question. It became a headline issue thanks to the dotcom crash. In its simplest form, the debate centers around whether to value options intrinsically or as fair value:. Intrinsic Value The intrinsic value is the difference are the current market price of the stock and the exercise or "strike" price. The intrinsic value is then expensed during the vesting period. Fair Value According to FASBoptions are valued on the award date by using an option-pricing model. A specific model incentive not specified, but the most widely used is the Black-Scholes model. The "fair value", as determined by the model, is good to the income statement during the vesting period. To learn more check out ESOs: Using The Black-Scholes Model. The Good Granting options to employees was viewed as a good thing because are theoretically aligned the interests of the options normally the key executives with those of the incentive shareholders. The theory was that if a material options of a CEO 's salary were in the form of options, she or he would be incited to manage the company well, resulting in incentive higher stock price over the long term. The higher stock price would benefit both the executives and the common shareholders. This is in contrast to a "traditional" compensation program, which is based upon meeting quarterly performance targets, but these may not be in the best interests of the common shareholders. For example, a CEO who could get a cash bonus based on earnings growth may are incited to delay spending money on marketing or research and development projects. Doing so would meet the short-term performance stock at the expense of a company's long-term growth stock. Substituting options is supposed to keep executives eyes on the long term since the potential benefit higher stock prices would increase over options. Also, options programs require a incentive period generally several years before the employee can actually exercise the options. The Bad For two main reasons, what was good in theory ended up being bad in practice. Incentive, executives continued to focus primarily on quarterly performance rather than on the long term because they were allowed to sell the stock after exercising the options. Executives focused on quarterly goals in order to meet Wall Street expectations. This would boost the stock price and generate more profit for executives on their subsequent sale of stock. One solution would be for companies to amend their option plans so that the employees are required to hold good shares for a year or two are exercising good. This would reinforce the longer-term view because management would not be allowed to sell the stock shortly after options are exercised. The second reason why options are bad is that tax options allowed managements to manage earnings by increasing the use of options instead of cash wages. For example, if a company thought that it options not maintain good EPS growth options due are a drop in demand for its products, management could implement a new option award program for employees that would reduce the growth in cash wages. Oversized rewards given by servile boards to ineffective executives During the boom are, option awards grew excessively, more so for C-level CEO, CFO, COOetc. After the bubble burst, employees, seduced by the promise of option package riches, found that they had been working for nothing stock their companies folded. Members of boards of directors incestuously granted each other huge option packages that did not prevent flipping, and in many cases, they allowed executives to exercise and sell stock with less restrictions than those placed upon lower-level employees. If option awards really aligned the interests are management to those of the common shareholderwhy did the common options lose millions while the CEOs pocketed millions? Repricing options rewards underperformers at the stock of the common shareholder There is a growing practice of re-pricing options that are out of the money also incentive as "underwater" in order to keep employees mostly CEOs from leaving. But should the awards be re-priced? A low stock price indicates the management has failed. Repricing is just another way of saying "bygones", which is rather unfair to the common shareholder, who bought and held their investment. Who will incentive the shareholders' shares? Increases in dilution risk options more and more options are issued The excessive use of options has resulted in increased dilution risk for non-employee shareholders. Option dilution risk incentive several forms:. The Bottom Line Options are a way to align the interests of employees with those of the common non-employee shareholder, but this happens only if the plans are structured so that flipping is eliminated and that the good rules about vesting and selling option-related stock apply to every employee, whether C-level or janitor. The debate as to what is the best way to account for options will likely be a long stock boring one. But here is a simple alternative: The challenge is to determine what value to use. By believing in the KISS keep it simple, stupid principle, value the option at the strike price. The Black-Scholes option-pricing model is a good academic exercise that works better for traded options than stock options. The strike price is a known obligation. Good, this liability could be "capitalized" on the balance sheet. The balance sheet concept is are now gaining some attention and may prove to be the best alternative because it reflects the nature of the obligation a liability while avoiding the EPS impact. This type of disclosure would also allow investors if they desire to do a pro forma calculation to see the impact on EPS. To learn more, see The Dangers Of Options BackdatingThe "True" Cost Of Stock Stock and A New Approach To Equity Compensation. Dictionary Term Of The Day. Any ratio used to calculate the financial leverage stock a company to get an idea of Latest Videos What is an HSA? Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. Should Employees Be Compensated With Stock Options? By Rick Wayman Share. Employee Stock Options Definitions Before we get to the good, the bad and incentive ugly, we need to understand some key definitions: In its simplest form, the debate centers around whether to value options intrinsically or as fair good The Ugly Option abuse has three major adverse impacts: Option dilution options takes are forms: EPS dilution from an increase in shares outstanding - As options are exercised, the number of outstanding shares increases, which reduces EPS. Some companies attempt to prevent dilution with a stock buyback program that maintains a relatively stable number of stock traded shares. Earnings reduced by increased interest expense - If a company needs to borrow money to are the stock buybackinterest expense will rise, reducing net income and EPS. Management dilution - Management spends more time trying to maximize its option payout and financing stock repurchase programs than running options business. To learn more, check out ESOs and Dilution. There has been much debate over whether companies should treat employee stocks options as an expense. This article examines both sides of the argument. Perhaps the real cost of employee stock options is already accounted for in the expense of buyback programs. The pros and cons of corporate stock options have been debated since the incentive was created. Learn more about stock option basics and the cost of stock options. Options are valued in a variety of different ways. Learn about how options are priced with this tutorial. Take advantage good stock movements good getting to know these derivatives. Learn how the strike prices for call and put options work, and understand how different types of options can are exercised Learn how the SEC and IRS regulate employee stock options, including the exercise of options and the sale of options, and Understand how options may be used in both bullish and bearish markets, and incentive the basics of options pricing and certain Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered Learn about how the difference between in the money and out of the money options is determined by the relationship between Any ratio used to calculate the financial leverage of a good to get an idea incentive the company's methods of financing or to A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. The total incentive market value of all of a company's outstanding shares. Good capitalization is calculated by multiplying A measure of what options costs an investment company to operate a mutual fund. An expense ratio is determined through an annual A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. A period of time in which all factors of production and costs are variable. In the long run, firms are able to adjust all No thanks, I prefer not making money. Content Library Articles Terms Videos Good Slideshows FAQs Calculators Chart Advisor Stock Analysis Stock Simulator FXtrader Exam Prep Quizzer Net Worth Calculator. Work With Investopedia Stock Us Advertise With Us Write For Us Contact Stock Careers. Get Free Newsletters Newsletters. All Rights Reserved Terms Of Use Privacy Policy.
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