A stock option gives an employee the right to buy a certain amount of company stock at a predetermined or discount rate. Stock options are a popular perk, and help motivate employees by letting them benefit from increased company profits. Once primarily offered to executives as a way to motivate them to boost company stock values, stock options are now offered to a wide range of employees for a variety of reasons.
By offering stock options companies can attract talented employees for a lower annual salary than they might ordinarily have to pay. This helps companies conserve cash. For example, technology start-ups typically offer stock options to employees. These companies may be low on cash, so they offer low initial salaries with the option of buying stock. If the company is later purchased or becomes successful, employees can earn large returns on their stock options. By some estimates more than 10,000 Microsoft employees became millionaires by 2000 thanks to the company's stock option program.
Pay for Performance
Stock options can also be used as an incentive to encourage employees to work harder. Because the option is worth more as the company grows, stock options create a link between performance and reward. This is primarily true for executives, whose actions can have more of an effect on company stock prices. Ordinary employees and managers may have little individual impact on stock prices, and so may not be as motivated by stock options in their everyday performance.
Tax benefits can accrue for employees taking advantage of statutory stock option plans. These plans require the employee to hold the stock for a certain period of time, such as five years, before the employee can sell it. Once the employee sells the stock, any increase in the value of the shares is taxed as a capital gain, at 20 percent tax rather than the employee's ordinary tax rate. For employees who earn enough to be taxed at a higher rate, such as the top 35 percent tax rate, this would represent a huge tax savings. Companies may also get tax benefits from stock option plans because a company can deduct, as operating cash flow, the intrinsic value of stock options, which is the market price minus the price offered to employees.
Stock options can also deter employees from leaving a company for a higher-paid job when salaries in their industry begin to rise. This is because when an employee leaves a company, she is usually required to sell any purchased stock at the current market rate. Although this may represent a profit, if a company's stock is still rising in value, the employee may decide she will make more money in the long run by staying where she is and buying more stock.
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