Employee Stock Options

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What are Employee Stock Options?

Employee Stock Options are granted to selected (senior) managers of a company according to certain terms. They carry the right (but not the obligation) to buy a certain amount of shares in a company at a predetermined price. An employee stock option is slightly different from a regular exchange-traded call option because it is not generally traded on an exchange, and there is no put component (where a profit is made from the underlying stock following).

Normally employees must wait a specified vesting period before being allowed to exercise the option. The idea behind the stock option is to align incentives between the management and the shareholders of a company. Shareholders want to see the stock price to increase, so (in theory) rewarding managers when the stock goes up aligns everybody's goals. However there are a number of reasons why this alignment is far from perfect in reality:

• Executives don't experience the same pain that stockholders do if the share price drops.

• The incentive to executives disappears if the company's stock price drops to a certain point below the exercise price.

• Options are given away too freely without sufficient regard to the dilution suffered by stockholders.

• Companies sometimes unwisely spend money on a stock repurchase in order to reverse the dilution caused by the exercise of options.

Also referred to as Stock Option Plan.

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Compare with: Employee Benefits  |  Phantom Stock Plan  |  Employee Stock Ownership Plan  |  Golden Handcuff  |  Golden Hello  |  Golden Parachute  |  Golden Handshake  |  Pro Forma Earnings  |  Treasury Stock  |  Unissued Stock

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