Many companies compensate employees and executives with stock options as an alternative to cash to provide them with incentive. While this can work in some cases, it also can lead to problems for the company that issued them as well as for other investors. Stock options are not always the solid investment that some claim them to be.
One of the arguments for providing stock options as compensation is that it helps line up the interests of executives of a company and shareholders of that company. In some situations, it does the opposite and causes executives to take on risky strategies to try to increase the value of their stock options. For example, an executive might seek out a merger for his company with the hope of increasing the share price of the stock so that he can cash in his stock options in the future.
The process of issuing large amounts of stock options to employees can actually negatively affect the other investors in a company. When stock options are issued, it lowers the total earnings for the company, which can lower the stock price at that time. Then when stock options are cashed in, it dilutes the future earnings potential for stock holders. In some cases, the company will go out into the open market to buy shares of stock when employees cash in their options. This leads to even more earnings being spent by the company.
Confusion for Investors
Stock options are not only for the employees of a company by can also be purchased by traders in the market. One of the drawbacks of stock options is that they can be very confusing for novice investors. This is not something that should be pursued by anyone without experience in the market. Trading stock options involves a using terms like call, put and exercise price. If you have never done this before, it could result in losing a substantial investment along the way.
Even though the thought of stock options is that they will improve the performance of upper level executives, the opposite is actually true. Companies that do not use cash incentives and use stock options to reward performance actually have the worst performance. Companies like General Motors and Kellogg use this strategy and have actually suffered because of it. Companies who use cash incentives in exchange for superior performance tend to perform better and create more profits along the way.