On Oct. 30, 2006, a Google executive purchased 2,541 shares of Google at $9 per share and sold these same shares the same day at $475 per share. The end result of this executive's trading activity was a net change of zero shares, but a net profit of about $1.18 million. How can executives buy the shares so cheap and then sell them at market value making a large profit? The method behind this is employee stock options, which are extremely popular with startups as a way to attract top talent without paying high salaries up front.
Basically, the company awards an employee an option that allows them to buy a certain amount of shares for a set price at a set amount of time. The employee purchases the shares from the company, which they can either keep as an investment or sell immediately, usually for a gain. Most incentive stock options, or ISOs, are tax advantaged, in that if the shares are sold in a qualifying disposition, which occurs at least two years after the options were granted and at least one year after they were exercised. The bargain element, or the difference between the exercise price and sale price, is not reported as income, a potentially huge tax savings.
Compensation By Other Means
Stock options aim to motivate managers by linking compensation with company performance, which is measured by share price. Unlike market-traded stock options that are sold for a premium, employee stock options are given either as a portion of salary or a bonus. These options allow employees to share in the success of their companies. For managers involved with new companies, stock options are an attractive means of compensation, as the exercise price is often very low. When the company starts to perform well, such as the Google example, the executives can exercise their options for large gains.
Stock options do have potential disadvantages for companies that use them, primary among them the possibility of diluting shareholder equity when an employee exercises them. For employees, the main disadvantage is one of liquidity, especially in a privately held company. Unless and until the company goes public, the options aren't equal to cash benefits. In fact, if the company doesn't do well, or fails to grow at a decent rate, the stock may actually lose value and ultimately become worthless. (See also: The True Cost of Stock Options and Lifting the Lid on CEO Compensation.)