Stock options give the holder the right, but not the obligation, to buy a company's stock for a specified price by a particular date in the future. A company often gives stock options as incentives or payments to employees, consultants, vendors and contractors. This allows the company to provide compensation without spending any cash. However, stock options have several disadvantages.
Because stocks represent ownership of the company, every stock holder in theory owns a piece of the company. When a stock option holder exercises his option, the number of company stocks go up. Also known as dilution, this situation means that each stock holder now owns a smaller piece of the company. If the stocks bought with the stock options give voting rights, the voting stock holders have less control over the company.
At the time the stock option holder receives the stock option, the exercise price usually equals the current stock price. The exercise price refers to the price at which the stock option holder can buy the company's stocks. While stock prices go up and down over time, the stock option exercise price remains the same. While the stock option holder may benefit from price increases, he may also suffer a loss due to price drops. Whether the stock option holder will gain from the transaction often depends on timing and luck.
Link to Performance
Stock option holders benefit from stock price increases, so companies often believe that giving out stock options may motivate employees, contractors and vendors to work harder for the success of the company. However, this weak relationship between performance and reward may not be enough incentive for good work performance. Stock price fluctuations often don't have anything to do with the performance of the company. Various external factors, such as the economy and market movements, can all affect the stock price.
Fees and Taxes
To exercise stock options, the holder has to come up with the money to buy the stocks. Because he may not have the cash readily available, the holder may not be able to take advantage of unexpected price increases. The ability for a cashless option exercise may be available, but it would not make financial sense unless the stock price has shot up dramatically. The stock option holder also has to pay taxes on when he purchases the stocks.