What are the types of stock options? What is the nature of each?

Traditionally, stock option programs have long been used by companies to align the interests of top leaders or "key" employees with the company and its shareholders. Now, however, more companies are beginning to view all employees as "key". As a result, broad-based option planning is becoming more common, especially after the late 1980s.

Extensive option planning is now the norm for high-tech companies, and is becoming commonplace in other sectors as a compensation strategy for overall asset enhancement. Many publicly traded companies such as Pepsico, Starbucks, Travelers Group, Bank of America, Merck and Gap, to name a few, have granted stock options to most or all of their employees. Many non-high-tech companies are starting to jump on the bandwagon, too.

By 2001, the National Center for Employee Ownership (NCEO) estimated that more than 10 million employees had received stock options. Other studies confirm this trend, with a study by Joseph Blasi of Rutgers University finding that ninety-seven of the top one hundred e-commerce companies offered options to most or all of their employees. A 1997 survey of more than 1,100 companies by ShareData Inc. and the American Electronics Federation found that 53 percent of respondents offered options to all employees.

A 1999 study by William Mercer showed that options are common in a wide variety of public companies. Seventeen percent of large public companies offer options to most or all of their employees.

What are stock options

Stock options are the right of an employee to buy a certain number of shares of a company at a certain price for a specific number of years. The price offered by the option is known as the "ratification" price, and is often the market price at the time of ratification. Employees with options hope that the price of the stock will rise so that they can operate (buy) the stock at the lower approval price and sell at the higher current price. There are two types of stock option plans, each with their own unique terms and tax relationships: nonqualified stock options and incentive stock options (ISOs).

Stock option plans allow companies and employees great flexibility*** to enjoy ownership, reward based on performance, and attract and retain talent. For some small companies with established growth aspects, options are a good way to retain capital while giving employees future wealth. They also make sense for public companies with good benefit programs. The impact of options on lowering stock prices is very small when the program is for all employees and can be compensated for by the potential productivity of the employees as well as employee retention of benefits.

Options are not a machine for buying and selling stock for the owners of a company, and they are inappropriate for some companies whose future growth is uncertain. They are also unattractive to small, limited-stockholder companies that don't want to go public or sell, because it's hard to create a market for those shares.

Stock options and employee ownership

Are options ownership? The answer to the question depends on which person you ask. Proponents believe that options are ownership because employees don't receive them for free and must spend money to buy the stock. Others, however, believe that option planning allows employees to buy and sell stock for an approved short period of time and that options do not produce the attitude that long-term ownership should.

The ultimate effectiveness of any employee stock ownership plan, including stock option plans, depends heavily on the company and its planning goals, the commitment to creating a culture of ownership, the training and education invested in interpreting the plan, and the goals of individual employees (whether they want to profit sooner or later). Stock options can be a meaningful catalyst for a company that has proven to have developed a true ownership culture, and Starbucks, Pepsico, Microsoft, and a number of other companies have paved the way for this, showing how effective stock option programs can be in getting employees to work like owners.

Practical Considerations

Generally, to design an option plan, a company needs to carefully consider how much stock is available, who will accept it, and how much workload will increase in order to approve the right number of options. A common mistake is approving too many options too quickly, leaving no additional options for new hires down the road.

The most important consideration in plan design is its purpose: Does the plan intend to give stock to all employees in the company or just sweeten the pot for a few "key" employees? Does the company intend to promote long-term ownership, or temporary benefits? Is the plan intended to create employee ownership or to create an additional income for employees? The answers to these questions are critical to defining the detailed plan features, such as qualification issues, distribution issues, pension retention, appraised value, holding time, and stock price.