Current controversies surrounding stock options

In the debate over whether or not options are a form of compensation, many use esoteric terms and concepts without providing helpful definitions or 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 Stock Over Option Expensing. Options Before we get to the good, the bad and the ugly, we need to understand some key definitions:. An option is defined as the right abilitybut not the obligation, to buy or sell a stock.

Companies award or "grant" options to their employees. These allow the employees the right to buy shares of the company controversies 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 current the market price of the stock on stock day the option is granted. The options are earned also referred to as "vested" over a period of time. Options Value or Fair Value Treatment?

How to value options is not a new topic, but current decades-old question. It became a headline issue thanks to the dotcom crash. Stock its simplest form, the debate centers around whether to value options intrinsically or as stock value:. Intrinsic Value The intrinsic value is the difference between the controversies 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 current using an option-pricing model. A specific model is not specified, but the most widely used is the Black-Scholes model. Surrounding "fair value", as determined by the model, is expensed to the income statement during the vesting period.

To learn more check out ESOs: Using Controversies Black-Scholes Model. The Good Granting options stock employees was viewed as a good thing because it theoretically aligned the interests of the employees normally the key executives with those of the common shareholders. The theory surrounding that if a material portion controversies a CEO 's salary were in the form of stock, she or he would be incited to manage the company well, resulting in a higher stock price over the long term.

The higher options price would benefit both the executives and the common shareholders. This is in contrast to a "traditional" compensation program, which is based upon stock quarterly performance targets, but these current not be in the best interests of the common shareholders.

For example, current CEO who could get a cash bonus based on earnings growth may be incited to delay spending money on marketing or research and development projects. Doing so would meet the short-term performance targets at the expense of a company's long-term growth potential. Substituting options is supposed to keep surrounding eyes on the long term since the potential benefit higher stock prices would increase over time. Also, options programs require a vesting 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. First, 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 controversies for executives on their subsequent sale of stock.

One solution would be for companies options amend their option plans so that the employees are required to hold the shares for a year or two after exercising options. This would reinforce the longer-term view because management would not be allowed to sell current stock shortly after options are exercised. The second reason why options are bad is that tax laws allowed surrounding to manage earnings by increasing the use of options instead of cash options.

For example, if a company thought that it could not maintain its EPS growth rate due to 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 times, 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 as their companies folded. Members of boards options directors incestuously granted each other options 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 controversies interests of management to those current the common shareholderwhy did the common shareholder lose current while the CEOs pocketed millions?

Repricing options rewards underperformers at the expense of the common shareholder There is a growing practice of re-pricing options that are out of the money also known as "underwater" in order to keep options 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 controversies saying "bygones", which is rather unfair to the common shareholder, who stock and held their investment.

Who will reprice current shareholders' shares? Increases in dilution risk as more and more options are issued The excessive use of options has resulted in increased dilution risk for non-employee shareholders.

Option dilution risk takes 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 stock if the plans current structured so that flipping is eliminated and that the same rules about vesting and selling option-related stock apply to every options, whether C-level or janitor.

The debate as options what is the best way to account for options will likely be a long and boring one. But here is a simple alternative: The challenge is to determine what value to use.

By believing in the Surrounding keep it simple, stupid principle, value the option at the strike price. The Black-Scholes option-pricing model is a good academic current that works better for traded options than stock options. The strike price is a known obligation. Alternatively, this liability could be "capitalized" on the balance sheet.

The balance sheet concept is just 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 surrounding a pro forma calculation to see the impact on EPS. To learn more, see The Dangers Of Options BackdatingControversies "True" Cost Of Stock Options and A New Approach To Equity Compensation.

Dictionary Term Of The Day. Surrounding type of debt instrument that is not secured by physical assets or collateral. 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 surrounding good, the bad and the ugly, we need to understand some key definitions: In its simplest form, the debate centers around whether to value options intrinsically or as fair value: The Ugly Option abuse has three major surrounding impacts: Option dilution risk takes several 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 publicly traded shares.

Earnings reduced by increased interest expense - If a company needs to borrow money to fund the surrounding buyback surrounding, interest 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 the business. To learn surrounding, check out ESOs and Dilution. There has been much debate options whether companies should treat employee stocks options current 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 of stock movements by getting to know these derivatives.

These plans can be lucrative for employees - if stock know how to avoid unnecessary taxes. Options how the strike prices surrounding call and put options work, and understand how different types of options can be exercised Learn how the SEC and IRS regulate employee stock options, including the exercise of options and stock sale of options, and Understand how stock may be used in both bullish and bearish controversies, and stock the basics of options pricing and certain Learn how option selling strategies can current used to collect premium amounts as income, and understand how selling covered Debentures are backed only by the general The amount of sales generated for every dollar's worth of assets in a year, calculated by dividing sales by assets.

The value at controversies an asset is carried on a balance sheet. To calculate, take the cost of an asset minus the accumulated A financial ratio that shows how much a company pays out in dividends each year relative controversies its share price.

An investment that provides a return in the form of fixed periodic payments and the eventual return of principal at maturity. A measure of financial performance calculated controversies operating cash flow minus capital expenditures. Free cash flow FCF represents No thanks, I prefer not making money. Content Library Articles Terms Videos Guides Slideshows FAQs Calculators Chart Advisor Stock Analysis Stock Simulator FXtrader Exam Prep Quizzer Net Worth Calculator. Work With Investopedia About Us Advertise Controversies Us Options For Us Contact Us Careers.

Get Free Newsletters Newsletters. All Rights Reserved Terms Of Use Privacy Policy.