Option, option, who wants a stock option?

June 1, 2000
A stock option gives an employee the opportunity (option) to purchase stock in the company at a later date at a predetermined price (the option price, usually based upon the price of stock at the time the employee joins the company).
1304qa Chang New

Q. How do stock options work?

A. A stock option gives an employee the opportunity (option) to purchase stock in the company at a later date at a predetermined price (the option price, usually based upon the price of stock at the time the employee joins the company). The nice part of the arrangement is that the employee does not have to pay for this privilege. The idea behind stock options is to align the goals of employees and investors by making employees part owners in the company. Employees can equate their extraordinary contributions to higher stock prices and are therefore motivated to make the company succeed. A block of shares (a grant) is set aside for an employee to earn over time (vest). Typically vesting occurs over four or five years, which means one earns the rights to buy 1/48th or 1/60th of the grant for each month worked. Vesting stops when the employee leaves the company, and usually the individual has to buy (exercise) or relinquish the option for all the vested shares shortly thereafter.

Q. I work for a private venture-funded company. The company has both common and preferred stock, but my options are just for common stock. Why?

A. First let me explain the differences between the two classes of stock. Owners of preferred shares are first in line to receive dividends or assets in case a company goes belly up; owners of common stock in a pre-IPO company have to wait for any leftovers. Institutional investors try to minimize their risk by demanding preferred shares, so companies issue new series (A, B, C, etc., with holders of the latest round first in line) of preferred stock with each round of funding. In reality, however, there is very little difference between the different classes of stock. When the company goes public or is sold, the preferred shares are usually converted to common stock—share for share; if the company fails, there are rarely significant assets left over to distribute, especially in the case of high-tech companies.

An important benefit to receiving options for common shares is that the perceived higher risk justifies lower option prices for the employees. Had your options been for preferred shares with an option price that is only a fraction of what investors pay, the IRS would construe the difference in price as taxable income for you. Because there are differences between the two classes, one can argue that there is no taxable income. So the short answer to your question is, the shares are more or less the same and there is nothing to worry about.

Q. How do I deal with disgruntled employees whose stock options are "under water" (that is, the stock price is below their option price)?

A. This is a very tough issue in today's volatile stock market—what was intended as a motivator can quickly become a dis-incentive when stock prices take a sudden downturn. The obvious solution is either to reprice the stock option or to issue additional shares. Repricing the stock has its problems. A purist would argue against repricing because it defeats the purpose of stock options, which is to allow the employee to share in the fortunes of the company, both good and bad. Repricing also causes some administrative problems. Procedurally, repricing requires retiring old shares and issuing new ones. If the total number of new grants gets large, there won't be enough shares in the option pool. Increasing the pool would require shareholders approval, and big institutional holders can become "purists" in this situation. Another problem with repricing comes from the new accounting rules that took effect in late 1999. The difference in dollar amounts is to be treated as compensation expense, which flows to the bottom line to depress earnings to further depress stock prices. Accounting rules are highly technical and can change, so you need to consult your accounting firm.

The bottom line is that management has to face the reality of running a business; in this case, you have to do what is right based on fairness in order to retain valuable employees. What employees can be responsible for is the performance of the company, whereas they have no control over stock-market speculations. My personal opinion would be that if the option price accurately reflects the valuation of the company, and the price of the stock drops because of poor performance, then there is no reason to reprice. On the other hand, if the option price is at the height of market speculation, but the stock drops significantly even though the company is doing well, then repricing is a way of restoring the original purpose of the option grant, a reward based on performance. What I am also saying is that management should take a big-picture, long-term view of the situation instead of reacting to random market fluctuations.

About the Author

Milton Chang

MILTON CHANG of Incubic Management was president of Newport and New Focus. He is currently director of mBio Diagnostics and Aurrion; a trustee of Caltech; a member of the SEC Advisory Committee on Small and Emerging Companies; and serves on advisory boards and mentors entrepreneurs. Chang is a Fellow of IEEE, OSA, and LIA. Direct your business, management, and career questions to him at [email protected], and check out his book Toward Entrepreneurship at www.miltonchang.com.

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