Why Issue Stock Options
Why do companies use stock options?
This is Andrew. He has issued a stock option to purchase up to 100 shares of common stock of Acme Inc.at an exercise price of $1 per share. In other words, when Andrew wants to exercise his options, he needs to pay $100 to Acme. But is doesn’t cost anything to Andrew today. Employees and employers alike sometimes finds it confusing if the employee would ever have to pay anything out of pocket.
But remember, the purpose is to incentivize the building of value. $1 per share is the value of the company at the time Andrew issued the options. If the company is sold 5 years later for $10 per share then Andrew will pay $100, get his hundred shares and sell those shares for $10 per share for a thousand dollars. Andrews upsize is $900 and he will pay taxes on that when he sells a share.
Let’s assume instead that Acme issues a common stock not options to Andrew. You would not expect that Andrew would pay a dollar per share at the time he issues the shares because Andrew is an employee and this is supposed to be equity compensation, not an investment.
So Acme issues Andrew a hundred shares of common stock that are worth a dollar per share and Andrew pays nothing for those shares.That looks alot more like compensation and the IRS agrees. Andrew will pay ordinary income tax on the value of the shares he receives.
The problem with that scenario for most employees is that unlike salary or cash bonuses, Andrew is not receiving cash to pay the tax with. That puts Andrew on a tough spot. By issuing stock options, Acme Inc gives Andrew the ability to wait and see if buying the shares worth $1 is worth it or not. If Andrew leaves Acme for another opportunity, then he may lose his options but at least he isn’t losing his cash. If he stays with the company and 5 years later a buyer purchases the whole company at $10 per share, then he can exercise the options and share in the value he created.