Stock Options

STOCK OPTIONS - AN EFFECTIVE COMPENSATION METHOD
Stock Options have become the greatest form of remuneration for big names in organizations across the United States (Hall, 2000). The senior executives, who are given this option, can buy shares of the company at what Hall (2000) describes as the “exercise price”. They could be given “at the money”, “out of the money” or “in the money” price (Hall, 2000). Stock Options are helpful in motivating the holders to perform for the benefit of the company and its future rather than immediate short lived benefits.
The difference between shares and stock options is that while shares are bought at the stock price, stock options are bought at exercise price. Thus, employers can control the price at which the stock options are granted. In addition, the stock option holders receive only “incremental appreciation above the exercise price”, while the shareholders receive the entire value of shares in addition to dividends (Hall, 2000). Companies can grant three times as many stock options to the holder as shares. Hence, in terms of value in the long term, Stock option grants are a more pragmatic way than stock grants, or even salary and cash bonuses as it provides a way of linking performance to how an executive gets compensated (Hall, 2000).
There are three types of stock options described in the article by Hall. In the exhibit 1.1 below, the description of each plan along with a relative view and comparison with the other two plans has been shown.
Exhibit 1.1:
Fixed Value Plan
Feature - Under this plan, for the entire duration, the employees holding stock options get grants of predefined value / fixed value that is a percentage of the executive’s salary
Frequency- The grant is provided every year and the value is adjusted. This plan is generally driven by comparison between how several executives are paid (Hall, 2000)
Risk- It can help in minimizing the chances of losing option holding employees to competitors
Link to performance- It doesn’t give enough motivation to the executive to perform well after a point Fixed Number Plan
Feature - The Fixed number plan involves issuing of a fixed predefined number of stock option grants as opposed to the fixed value in the Fixed Value plan.
Frequency- Stock options issued each year
Risk- Reduced chances of losing senior executives to competitors
Link to performance- It is directly linked to performance as the company’s stock price would determine the total value of the options at any point; better way of associating an executive’s compensation to performance
Megagrant Plan
Feature - Under this plan, the executives get large grants at the beginning itself at a fixed price in the form of a fixed number of options
Frequency- Grants would not be provided every year
Risk - If the stock price rises; it would be of great value for the option holder. But, if the price falls, he/she might be inclined to quit unless the company reprices the options. The chances of losing talent are much higher if the company’s performance is not stable.
Link to performance - In a stable environment with less volatility, this provides the most amount of value to the option holder
As highlighted by Hall (2000), the choice of the right plan from an employer’s point of view completely depends on the size and the volatility of the market that the organization is operating in. Fixed Value plan is suited for non senior employees who do not hold a lot of critical decision making responsibilities. Fixed number plan is suited for those companies that are operating in a highly volatile industry and have a higher risk of losing top talent to other firms. On the contrary, Mega grant plan is best suited for large companies that are operating in a stable environment and do not face the risk of losing talent.
From an employee’s point of view, it depends on how the executive weighs risk against incentive. If I were given an opportunity to choose, I would go for the Mega grant plan as I am relatively conservative when it comes to handling risk. It would be a good choice as it gives me a big amount right in the beginning which is a huge advantage if the company performance is stable. In case the volatility increases and stock price falls, I would still have the flexibility to move to another organization.
Between stock grants and mega grant stock options however, I would prefer the former because of two reasons. First reason being that although stock options would give me a huge incentive in terms of value and probably not as much risk as stock grants, it would not give me the freedom to buy or sell shares at my will. Second reason is that dividends are almost always guaranteed if I hold stocks of the company unlike stock options. As stock grants would give me relatively more power or freedom to decide, I would prefer stock grants over stock options.
References: Hall, Brian J. (2000). What You Need to Know About Stock Options. Harvard Business Review. Reprint Number R00205

References: Hall, Brian J. (2000). What You Need to Know About Stock Options. Harvard Business Review. Reprint Number R00205