Employee stock option plans: a quick lesson

What are options, anyway?  A stock option represents the right, but not the obligation, to buy or sell stock at a specified price by a certain date.  In other words, with stock options you can choose to buy or sell stock at a given strike price, but you don't have to.

Individual companies grant stock options

I first became aware of stock options during the Internet Boom of the late 1990s / early 2000s.  I would read in the news that Wealthy McCEO and many other company executives were getting crazy rich thanks to stock options.  Companies can grant stock options to employees, which often encourages employees to stick with the company for an extended period of time.

How employee stock option plans benefit the company and the employee

How would stock options entice an employee to stay at a company?  Here’s an example.  Suppose Company XYZ is a public company and XYZ stock trades for $10/share.  Upon hiring a top-level manager (let's call the manager by Smarty Pants), XYZ might grant Smarty Pants the option to buy 10,000 shares of XYZ @ $10/share.

With shares of XYZ trading for $10/share, Smarty Pants probably wouldn't want to do anything with those options.  Why bother, since she could buy shares for the same price on the open market?  Typically companies don't allow the option holder to exercise the option (i.e., perform the purchase prescribed by the option contract) right away, anyways. 

Companies control when the employee stock options become vested (i.e., eligible for exercise).  XYZ might tell Smarty Pants that her options become 50% vested after two years and 100% vested after four years.  This would mean that after being with the company for two years, Smarty Pants could exercise the option to buy 5k of those 10k shares @ $10/share.  After four years she could exercise the option to buy the remaining 5k shares, still @ $10/share.

Suppose a year passes and XYZ stock becomes an increasingly attractive investment.  Shares of XYZ now trade at $20/share.  Ho, ho, ho - Santa Claus just came to town.  Just for sticking with the company, Smarty Pants could -- in a single transaction -- realize a gain of $10/share.  But wait… her options aren’t vested yet.  They become 50% vested two years (not one year) after the initial grant.  Bummer.  Now she’ll have to stick around for another year to realize that potentially saucy gain.

Suppose yet another year passes, and XYZ now trades for $25/share.  Hot dog!  Smarty Pants can buy 5k shares @ $10/share only to turn around and sell them on the open market for $25/share.  Putting this transaction into the numbers:

Purchase price = $10/share * 5,000 shares = $50,000

Sale price = $25/share * 5,000 shares = $125,000

Net gain = Sale price - purchase price = $125,000 - $50,000 = $75,000

Smarty Pants was rewarded for sticking with the company as the company's stock performed well.  During that time period, Smarty Pants also had incentive to help the company perform well.  If she were to help the company to perform better, in theory XYZ stock might trade at a higher price per share and she could end up with more dough for herself.

Employees won’t always make a profit on stock options

Of course, if investors had viewed XYZ stock as a decreasingly attractive investment then the share price might have dropped over that two-year initial vesting period.  If the stock performed so poorly then Smarty Pants’ options might have expired before she got a chance to exercise them in a profitable transaction.

What do I mean by expire?  Just as companies control stock options vesting periods, companies also control when that contract expires.  Like I mentioned above, stock options represent the right -- but not the obligation -- to purchase shares by a certain date.  If XYZ stock traded at no higher than $8/share between the time the options were vested and when they expired, then there would be no reason for Smarty Pants to exercise the options.  If she were to go through with it, she’d lose $2/share on the transaction (since her option was to purchase shares at $10/share, whereas the market was paying up to $8/share).  That sounds like a bogus deal because it is a bogus deal.

Impact of employee stock option plans on share price

Although employee stock option plans can be good for the company and good for the employee, investors should be aware of a company’s stock option granting practices.  These practices can add downward pressure to a company’s share price.  Thinking in terms of supply and demand, when an employee buys shares through a stock option plan then more shares all of a sudden become available for trading (and therefore supply increases).  More supply means more pieces to the same size pie, so each piece has to be a little smaller.  Following an employee stock option exercise, each outstanding share is worth some fraction less than it was before. 

Companies can offset the dilutive effects of option exercises by buying back shares on the open market.  If a company buys back more shares than are issued into the trading pool, the number of outstanding shares decreases and so each share -- in theory -- becomes worth a little more.  Something to consider!

Insider activity

When employees of a public company buy or sell shares of that company, that’s commonly referred to as insider activity.  Insider activity is completely normal, and you can investigate insider transactions yourself.  This information is available online, and one site I visit to obtain information on insider transactions is Yahoo!’s insider activity area like this one.  On that page we can see that on 25 October 2007, a Yahoo! Directory named Terry Semel exercised options to net more than $8 million in a single swoop.  Not too shabby.

Some people take into account insider activity when constructing opinions on a company or a company’s share price.  People buy and sell shares all day, but presumably directors know more about the company than the average investor does.  If a director buys shares on the open market, that’s often interpreted that the director has faith in the company. 

When an insider dumps a lot of shares, some believe that demonstrates lack of faith in the company.  While that may end up being the case sometimes, remember that insiders are individual people.  Insiders have their own financial wellbeing to consider, and sound principles like diversification apply to them, too.  Just because an insider sells shares or exercises options, that doesn’t necessarily imply upcoming problems.  Some insiders participate in stock option exercise plans that force regular, periodic exercising of options and selling of shares at predetermined time intervals.  This allows insiders to sell stock in a way that some consider less predictive.

Insider activity is interesting to look at, but it doesn’t necessarily imply anything.  It can be a useful piece of information when evaluating a stock, but I strongly would advise against using it as the sole indicator of whether to buy or sell shares.

Summary

Stock options can be good for the company, good for the employee, and good for the investor (for example, if the company ultimately spends less on hiring since their employees stick around).  Stock options can also be a negative for a stock, so be aware of what's going on and you'll have a more informed and complete view of a company and that company's valuation.

Long story short, I hope you and I get rich off of stock options ...  Cha-ching!