Stock options

Definition

Stock options are contracts that give an employee the right to buy a certain number of shares of the company's stock at a predetermined price, known as the exercise price, within a specified time frame. These options serve as a form of compensation and can align the interests of employees with those of shareholders, incentivizing workers to contribute to the company's growth and performance.

5 Must Know Facts For Your Next Test

1. Stock options can be a key part of an executive compensation package, providing a potential for high financial rewards if the company's stock price increases.
2. The exercise price is usually set at the market price of the stock at the time the options are granted, meaning employees benefit from any increase in stock value after that point.
3. Employees typically face a vesting period, meaning they must wait for a specified amount of time before they can exercise their options and purchase the stock.
4. Once employees exercise their stock options, they may owe capital gains tax on any profit they realize if they sell the shares later at a higher price.
5. Stock options can create a sense of ownership among employees, motivating them to work towards increasing the company's performance and share price.

Review Questions

• How do stock options align employee interests with those of shareholders?
  • Stock options align employee interests with shareholders by giving employees a financial stake in the company's success. When employees are granted stock options, they benefit from an increase in the company’s stock price, incentivizing them to work harder and contribute to the overall growth of the company. This shared goal can lead to improved company performance and greater shareholder value.
• Discuss the impact of vesting periods on employee motivation regarding stock options.
  • Vesting periods are crucial because they require employees to stay with the company for a certain time before exercising their stock options. This structure encourages loyalty and long-term commitment, as employees may be motivated to continue performing well to earn their options. Additionally, knowing that their potential financial reward is tied to the company's future success can further enhance their motivation to contribute positively.
• Evaluate how stock options could influence corporate governance and decision-making within a company.
  • Stock options can significantly influence corporate governance and decision-making by aligning executive actions with shareholder interests. When executives hold stock options, their compensation is directly tied to the company's stock performance. This alignment may encourage executives to prioritize long-term growth strategies over short-term gains. However, it can also lead to risky decision-making if executives focus solely on increasing short-term stock prices at the expense of sustainable business practices, highlighting the need for balanced governance mechanisms.

Related terms

equity compensation: A type of non-cash pay that represents ownership in the company, often provided in the form of stock options or restricted stock units.

vesting period: The period during which an employee must remain with the company before they can exercise their stock options and gain ownership of the shares.

capital gains tax: A tax on the profit made from selling an asset, such as stocks, which becomes relevant when stock options are exercised and sold.