Business Valuation For Dummies
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Business owners can include stock options as a method to increase managerial effort. A stock option provides its holder a future opportunity to buy the company’s stock at a predetermined price — the call price.

Frequently, the option’s call price is its current price, although there is no single method for determining the call price. Typically, a stock option can be exercised only during a specified period of time and at some point the option expires.

If the company’s stock value increases, the holder of the stock option makes a very quick financial gain through the difference between the call price and the higher future price. If the company’s stock price falls below the call price, the holder of the call is under no obligation to buy the stock and the option isn’t exercised.

Any holder of a stock option has an incentive to work harder to increase the company’s stock price.

Your company offers its manager a 1,000-share stock option that can be exercised six months from now at the current price of $20.00 per share, the call price. If six months from now the stock price is $25.00 a share, the manager can make a quick $5,000. Here’s how:

  1. The manager exercises the option and buys 1,000 shares at $20.00 per share.

    The total cost is $20,000.

  2. The manager sells the 1,000 shares at the market price of $25.00 per share.

    The revenue from the sale is $25,000.

  3. The difference between the revenue and cost is the manager’s financial gain, or $5,000.

If instead the company’s stock price decreased to $15.00, the manager wouldn’t exercise the option. Thus, the manager with a stock option has no risk of loss.

Stock options can carry a variety of restrictions. Vesting requirements limit the manager’s ability to sell the shares or options to ensure the owner’s and manager’s interests are the same.

Typical vesting requirements include requiring the manager to continue to work for the company for a specified number of years; some specific event to occur, such as an initial public offering (IPO); or certain performance targets to be reached, such as sales or profit goals.

In addition to increasing managerial effort, stock options can be used by start-up companies to reward employees, while keeping wages and salaries low. Thus, a new firm’s employees have a strong incentive to work hard to make the company successful.

One advantage of stock options over profit-sharing is managers focus more on the long-run value of the stock. Profit-sharing may lead to a shorter-term focus because it’s based on current outcomes.

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