Stock Options– Striking Fools Gold: Most Don’t Understand Basic Reality of Stock Options; Harbor Unrealistic Expectations…

The 90-10 Stock Options Reality; 10% of stock options are a source of personal wealth for some, while 90% are disappointment for most; stock options is a topic of contentious debate…

Many employees, management join a startup (or established business) and work incredibly hard at sub-market salary in the hopes of ‘striking gold’… However, sobering reality is that unless you are one of the very few first employees, you’re probably not going to get more than a nice hiring bonus, even if the company does well for itself…

However, it’s become common practice in many companies to offer the benefits of stock options to not only top-paid executives, but also to rank-and-file employees. But; What are stock options? Why are companies offering them? Do they accomplish their purpose?

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A stock option is the right given to employees, management by employers to purchase (‘exercise’) a certain number of shares of a company’s stock at a pre-set price (‘exercise or strike price’) over a certain period of time (‘exercise period’)… Most stock options are granted on publicly traded stock but it’s possible for privately held companies to design similar plans using their own pricing methods… Usually the strike price is equal to the stock’s market value at the time the option is exercised (or granted), but not always; it can be lower, higher depending on the type of option…

In the case of private company, the strike price is often based on the price of shares at the company’s most recent funding round… and employees, management gain a benefit (i.e., profit), if they can sell their stock for more than they paid at the strike price… According to National Center for Employee Ownership; most people covered by broad-based stock options may receive amounts equal to 12%-to-20% of their salaries, from the ‘spread’ between– what they pay for their options and what they sell them for…

The typical explanation for the use of stock options is that these compensation vehicles enable companies to– attract, retain, motivate… employees, management, as incentives for superior personal performance which will translate into increase shareholder value… While the explanations seem reasonable on the surface, the whole concept hinges on the basic assumption that employees, management understand how stock options work… Yet according to David F. Larcker and Richard A. Lambert; many employees, management tend not to understand the basic economics of stock options; in fact, many employees, management harbor unrealistic expectations on how much stock options will increase their personal wealth…

According to survey of workers, management who own stock options; 39% said they knew ‘little’ or ‘nothing’ about their options, another 35% said they knew only ‘something’… As a strong indication of serious knowledge limitations, 11% of the respondents had allowed options to expire, essentially rendering them worthless. Finally, 52% said they knew ‘little’ or ‘nothing’ about the ‘tax’ implications of exercising options…

According to the ‘Options Clearing Corporation’; around 17% of all options contracts got exercised and about 35% expired worthless, and almost half (48%) of the rest got bought or sold to close in the open market… Now it’s difficult to believe that stock options will have their desired effect on employees, management behavior, if these people don’t understand the basic economics of stock options and how they work…

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Proponents argue that stock options help overcome the ‘agency’ issue, which is inherent in the separation of ownership and control of the firm… they argue that stock options align employees, management, shareholders interests, and motivate them to focus on maximizing share value… Critics argue that use of stock options cause employees, management to engage in risk-taking, unethical behavior, manipulation of company performance… which defeat the very purpose of stock options. However, the relevant question is: Do stock options really work? Do they motivate people to think like owners?

According to Katherine J. Klein, Edward J. Carberry, Mathis Schulte; it’s a ‘qualified yes’: Stock options ‘work’ if employees expect their options will bring them financial gain… however, if employees, management accept sub-market wages and employers do not deliver financial reward via stock options payoff, then use of stock options can backfire; diminishing employees, management commitment, work hours, retention…

According to Warren Buffett; though options if properly structured, can be an appropriate and even ideal way to compensate, motivate people; however, there are some CEOs who are incredibly over-paid via stock options and producing very poor business results…

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In the article Myths About Stock Options by Corey Rosen writes: Stock options and other forms of equity granted to employees, management are an institutionalized part of compensation at many companies. Hence, it’s important to separate myths from reality about how these plans work:

  • Myth– Most People Getting Equity Work for High-Technology Companies: One of the most prevalent and misleading misperceptions was (and still is) that most employees, management getting stock options or other forms of equity, work for high-technology companies and most of which are small, pre-IPO ventures… Not true; in fact, about 15% to 20% of all public companies give stock options or other forms of equity and many of these are outside the technology sector…
  • Myth– Most People Give Up Pay to Get Options: Economists say– there is no free lunch, so if someone gets stock options or other forms of equity they must be giving up pay or benefits. To be sure, some employees, management have done just that. There are lots of people who were lured to start-up companies at lower salaries in return for substantial stock option packages, but these people are the exceptions… According to Joseph Blasi and Douglas Kruse; most employees, management that are getting stock options are paid about 7% more in wages than comparable people in comparable companies that do not give stock options. The fact is that it’s very difficult to lure all but a handful of risk-takers to jobs whose base pay and benefits are not comparable to what could be earned elsewhere. Stock options or other forms of equity are ‘gravy’ to help companies distinguish themselves. In the technology sector, most companies give stock options because its become part of the ‘ante’ to the game…
  • Myth– Stock Options Make You Rich: Equity is probably not going to make more than a handful of people rich, but for most holders, it provides a worthwhile additional financial benefit… And for most equity granting companies, it provides a way to link employees, management, corporate fortunes for the long-term. Equity is not the ready path to riches, as it may seem to some… nor magic elixir for corporate recruitment, retention, motivation as it may seem to others, but stock options have many advantages to both sides, as an important incentive…

In the article Stock Options Are For Suckers Who Accept Below Market Pay by Financial Samurai writes: There is a saying in the poker-playing community; if you don’t know who the sucker is at the table, it’s you… Don’t be a sucker; before you accept stock options as part of your compensation, at least understand the basics economics about stock options, e.g.; your number of shares, exercise price, shares outstanding, vesting schedule, status of your unvested options if the company is acquired…

Most important, you must thoroughly understand the workings of the company you are working for (or intend to work for), e.g.; their basic business model, growth strategy, how they make money or plan to make money…

Another important factor is the company’s management team; who are they, why are they there, what are their plans and timeline… what are their motivations– are they there to build a great company, or a quick flip… These type issues will tell you a lot about the real value of your stock options… It’s unfortunate, but some companies aggressively promote the thinking that stock options are the path to riches when, in fact, they can be worthless, for example; 9 times out of 10 stock options are great for the executive team, but crappy for everyone else…

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But the reality with most companies is that– they either fail or just muddle along… with very little possibility for stock liquidity any time soon, if ever… So, if you are expecting to get rich off of stock options, then think again… If you happen to own stock options or in a position to get them, then that’s great and you may benefit, but don’t get distracted, run your life as if they don’t exit and hope for a lottery event… Company stock options can be a source of great wealth, but they can also be a source of great confusion, unrealistic expectations…

According to Veronica Dagher; all too often many people don’t know about how their stock options work and that can lead to big problems… options come with specific rules attached– and ignoring them can have serious consequences, e.g.; you can end-up facing substantial tax hits, or even losing the right to exercise the stock options entirely…

So if you join any company (i.e., start-up or established company); do so because you are passionate about the– company, opportunity, coworkers… and not because of the– pot of fools gold– stock options…