Companies grant stock options to motivate employees. A stock option is a type of investment that allows the holder to buy a certain number of shares of a company’s stock at a locked-in price. For example, suppose a company you work for offers a stock-option package that allows you to buy 1,000 shares of the stock at the prevailing market price on the day you received the options. You can hold on to the stock options until some future date and then make a tidy profit.
When employees exercise stock options, they get to buy shares of the company's stock at the locked-in price. If they immediately sell the shares after buying them, they get to pocket the difference between the old price and the current price. In other words, exercising stock options means instant profit. So any employee holding stock options has an incentive to work hard to get the company's stock price to increase.
If, on the other hand, a stock's price falls after stock options are issued, the employee doesn't lose anything tangible. Owning stock options doesn't mean you have to exercise them. It only means you have the right to exercise them if you wish.
Besides offering an incentive to employees, stock options also offer another advantage. Granting stock options allows a company to offer financial rewards to employees today but postpone paying for it until later. For example, a generous stock-option package might convince an employee to take a job in a start-up company that can't currently afford to pay high salaries. The employee forgoes a high initial salary for the potential of a huge reward later.
Stock options essentially pay for themselves by motivating employees to increase the value of the business and thus generate their own financial reward. In contrast, a salary doesn't have the same motivating effect. For example, an employee might not work hard to develop a business when there is no financial benefit to putting in more effort than it takes to simply keep his job. But with stock options in hand, that employee might go the extra mile, essentially generating his own financial reward by working to strengthen the company and increase the value of its stock.
Stan Mack is a business writer specializing in finance, business ethics and human resources. His work has appeared in the online editions of the "Houston Chronicle" and "USA Today," among other outlets. Mack studied philosophy and economics at the University of Memphis.