What award of stock options means?

Answer 1

It means you work for a really cheap company, or you make more money than they can deduct from their corporate taxes.

When you're awarded stock options, you have permission to buy at a stated price a stated amount of your company's stock. Maybe the option is for 100 shares at $20 per share. If the stock goes up to $30, you buy the stock with the option and you've made $10 per share, right away. In the language of derivatives, incentive stock options are a form of covered call. The tax treatment is a little goofy, tho: there are two holding periods. You have to hold the stock you buy at least two years from the time you receive the option, and at least one year from the time you exercise the option by purchasing the shares. If you meet both holding periods (which are concurrent, incidentally; most recipients exercise these within the first year they have them, so that when the two-year period ends they're free to sell) you pay taxes on the profits at the long-term capital gains rate, which is 15 percent. Sell before both have elapsed and you pay tax at the ordinary income tax rate, which is quite a bit higher.

Now understand, these things cost the company very little, if anything. If a company has to go out on the market and buy the options from a brokerage they'll pay the premium charged on an option...but they can also generate a new issue of stock, hold it, and allow the options to be redeemed for that stock. In that case, the options really are free.

Now as to the two reasons to issue options.

The first is if you're a rank-and-file worker who receives them. That's where the cheapness part comes in. An option is given in lieu of cash compensation...so if you pay a $100,000 employee half in cash and half in options, and you have a lot of these guys, you save a pile of money.

The other has to do with the tax treatment of executive compensation. The cash you pay an officer of your company is deductible from your pretax income up to the sum of $1 million. If you want to pay your CEO $20 million, and you want to be able to deduct it all, you have to give him $19 million in incentive stock options and $1 million in cash. The worst abuse of this I ever saw was the CEO of nVidia, the computer graphics chip maker. They paid him $35 million, but only $10,000 of it was in cash.