Companies issue stock options as a way to simultaneously reward privileged employees (like executives), and also to give them an incentive to continue their successful performance in the future. Stock options allow people to purchase shares in a company at their current price, but at some point in the future. If the stock rises in the meantime, purchasing shares using stock options therefore allows employees to make an instant profit by, in effect, purchasing at a discount. In contrast, if the stock falls, then exercising their options would mean buying the shares at an unprofitable premium. Companies issue stock options to employees, particularly at very high levels, in the hope that it will encourage them to continue to work hard, or to work harder, thus increasing profitability and therefore increasing the stock price.
Stock options, like all options, are a particular type of financial contract in which the seller gives the buyer the right, but not the obligation, to purchase an asset at today’s prices but at a future date. This makes them different from two similar financial instruments, actual stocks and futures. A stock option is not equivalent to actual stock ownership: the person holding the options is not actually an owner in the company in question until they exercise their options and purchase shares. In addition, stock options are different than futures because a futures contract obliges the holder to purchase the asset at the specified date, whereas a stock option merely gives them the right to do so. (In general, this right is only exercised if the stock price has increased and therefore gives the stock option holder the possibility of a quick profit.)
Typically, when companies issue stock options to their employees, they will contain several basic components. First, they will specify the price at which employees can purchase the stock (normally, the price at the time the option is issued), and the amount of shares they have the right to buy. Second, they specify a time limit, beyond which the option expires and the stocks can no longer be purchased at the privileged price. Finally, they may limit the option holder’s ability to trade the options to other investors.
The greatest number of stock options are given to executive-level management as part of their regular compensation, in addition to their salary and other benefits. However, new startups may also choose to issue stock options to other management or even to non-management employees on a regular basis. This is because companies which are just starting out often have highly committed employees at all levels of the organization, and are even more often short of cash to offer fully competitive salaries. Offering stock options are a way of encouraging people to commit to a company at a time when it is not yet clear whether it will be entirely successful in the market. Historically this has occasionally led to a small number of fortunate lower-level employees becoming extremely wealthy when the new company they work for becomes extraordinarily profitable.