A stock option is a form of compensation that allows the option holder the option, but not the requirement, to exercise stock options at some point in the future at a specified price.
For example, if you are an employee at Microsoft and they have awarded you 1,000 stock options with an exercise price of $20, then you have been awarded the option to exercise that stock at a price of $20 at some time in the future, preferably when Microsoft's stock is above $20.
For startups, stock options are used as a means to compensate employees with the potential for a large gain at some point in the future. Since startups are cash poor, they do not have the ability to pay the same salaries to their employees as more established firms, so they use larger amounts of stock options as a means to offset the lower cash salary paid to their management teams.
Two types of stock options:
1. NQO's (Non qualifying stock options) - are most widely used. However, when an employee exercises the options, he/she is taxed at the time of the exercise (even if no cash is received) and taxed again when they sell their shares, if any capital gains are earned on the sale of the stock.
2. ISO's (Incentive stock options) – have better tax treatment for employees, but are rarely used today because of a $100,000 limit. An employee can only receive up to $100,000 in ISO's each year, which in today's corporate world, most executives would sneeze at. The upside to the ISO is that employees who exercise them are only taxed once at the time of the stock sale, they are not taxed when they exercise the option.
Stock options have received a lot of criticism of late in the media due to the payment compensation plans of many top executives at public firms. The one major gripe about stock options is that they do not align with the long-term success of the business, as they were initially intended especially since executives have no downside risk associated with options.
A more accurate compensation plan that ties to the long-term performance of the company is to give its employees actual stock. Providing employees with stock, rather than options require that employees bear downside risk if the stock price falls as well as garner the value from the upside if the stock price increases. By tying risk to executive compensation, executive compensation is much more closely linked to actual firm performance in the short and long terms.
For start-ups, that are not publicly traded, options are a valuable way to link executive compensation with the long-term success of the company. Because executives are receiving less cash compensation, the options provide the only significant value to them. The firm must either get acquired or go public for the options to be exchanged for cash in which case, the executives have every right to be incentivized by seeing their company do well.
After all, nobody wants to buy a struggling firm, and you can only go public after you have reached a certain size. Stock options can get quite complicated from an accounting, tax, and legal aspect, but from a pure management stand point, they are an excellent way to attract and retain key employees in your early years.