Compensation for the highly paid executives in public companies often includes the base salary, bonus, all other compensation, share based awards, option based awards and pension value.  One of the most mysterious components of that compensation is the stock options.   What are stock options and how do we determine their value?

Stock options are benefits in the form of an option given by the company to an employee to buy stock in the company at a discount or at a stated fixed price.  The employee must purchase the stock with their own money at a predetermined exercise price.  The employee typically has to wait a certain period of “vesting time” until the option can be exercised. When the option vests, the employee gains the right to sell or transfer the option. This method encourages employees to stick with the company for a long term.

If the exercise price is lower than the value of the stock at the time purchased then the options are valuable.  Options generally have an expiration date.

For example, let’s say that Company A gives or grants John Smith options to buy 100 shares of stock at $2 per share.  John can exercise the option starting on June 1, 2016.  On June 1, 2016 the stock for Company A is worth $6.  John’s choices are:

1. Convert the options to stock by buying it at $2 per share and then selling all the stock after the specified waiting period. If John sold 100 shares he would make a profit of $400 (bought at $200, sold at $600).
2. Sell some of the stock after the waiting period and keep some to sell later. Stock would be bought at $2 per share first.
3. Change all the options to stock, buy it at the discounted price and keep it with the idea of selling it later when the share price has risen (although there is no way to predict if that will happen).
4. Choose not to exercise the options by the expiration date and lose the options.

In order to determine the value of stock options we take the profit in option 1. even though we do not know exactly how John will proceed.  When determining giving capacity I generally take stock options with a grain of salt, but it does offer an interesting glimpse by seeing what the profit on the options they hold could be.