Stock options are one of the most used and least understood tools in the compensation toolbox. Recently, a new optionee asked if I could explain stock options in a manner that even his dog could understand. I have included my answer below.
"Come here Rover, I have got something to explain to you. Stock Options ....STOP scratching yourself and listen....Stock Options are an offer from the company that allows you to buy company stock at a later date. The cool thing...STOP sniffing my pant leg....The cool thing is that the company will let you buy that stock at today's price. If the stock price goes up then you get a great deal. If it goes down, then you get nothing (or close to it). A couple of key details....COME back here and stop rubbing noses with that cute poodle...If you quit your job any options that haven't vested will probably go back to the company. In fact, ...GEEZ stop pulling at your leash!... the shares you do exercise may also be bought back by the company (I would have to read the plan and agreement to know for sure.)
...What did you ask boy? How do you value them?... A private company is required by IRC 409A to have a reasonable valuation performed on the company at, or near, the time of grant and again at least annually or whenever the value may have materially changed. A public company generally uses the day’s closing or average price. ....OK, just hang on and I will get you a treat....The 2000 options you received may have a starting value of a few dollars or a few thousand dollars. It depends on the number of shares outstanding and the total value of the company. The final value will depend on the success of the company, the change in stock price, and your ability to keep your options etc. ...I'm not sure what’s in the treats, probably beef and bones or something like that...They could be worth nothing or they could be worth millions! The key is working to raise the value of the company as a whole.
I hope this helped a little. Now roll-over and let me rub your tummy.
As I re-read my response I realized that although the dog may now understand the basic concept of a stock option, they would not be able to understand the true risks and benefits of such a complex tool. Stock options, like many forms of equity, have inherent upsides and downsides. We tend to focus on the positives when we choose to use them and emphasize the negatives when we use something else. We seldom provide a fully colored, 3-dimentional picture of how these instruments work in a world of volatile stock prices, complex income and tax ramifications and various financial planning strategies.
When we choose to use complex compensation instruments during a period of unpredictable markets, we must also provide far more training and resources to our employees. Similar examples can be made for many types of equity instruments and nearly every form of performance-based pay. We short-change our employees and our companies by not ensuring that our employees truly understand the what, why and how of every compensation program we offer.