I will not aver that Diet Coke is the only good thing in my life, but it has always been there for me: inexpensive, sparkly, sweet, peppy, and non-fattening. Through the doldrums of work and the highlights of roleplay, I can rely on Coke to be just the same as it always has been. (Aberrations like New Coke notwithstanding.)
Coca-Cola, as a company, has done little to earn my undying devotion, apart from putting out a consistent product at a cost less than most companies charge for bottling water. Yesterday, however, they did something of tangible good—and something particularly difficult for a large corporation to do. They announced that they would list stock options an expense in their financial statements from now on.
This is probably totally meaningless to the majority of you. I’ll start at the very beginning. You can skip the chunks you already understand.
What is a stock option, anyway?
In brief: a stock option is a promise from some party to sell a share of stock in a specific company for a fixed price within a specified time range. For example, I could say to you, “If you pay me a $1.00, I’ll promise to sell you a share of Coca Cola for $50.00 any time in the next five years.” If you paid me the dollar, you would now have one option to buy Coca Cola stock from me.
The kind of stock option you hear about most often isn’t a transaction between third parties, however (though that’s perfectly possible and, I believe, common—sort of the flip side of short-selling. But I won’t go into that for now.) Usually, stock options go more like this: John works for Company X, whose stock is worth $10.00 a share. Company X likes John’s performance, so they tell him, “We’re giving you 10 stock options for shares in Company X, at $10.00 per share.” The idea is to give John incentive to make Company X’s stock worth more money. Right now, John’s stock options are worthless, because he can buy shares on the open market for $10.00. But if Company X’s stock was worth $15.00 a share, then he could exercise his options, then turn around and sell the stock he’d just bought and make a $50 profit on the deal. The theory behind giving employees stock options is sound—it gives the employee, like the company’s shareholders, an interest in seeing the stock’s value rise. And it’s better than handing out actual stock, because stock has value whether it goes up or down, while stock options are only valuable if the stock rises.
Sidenotes on additional complexities: stock options are sometime priced below market value, giving them some value right away, but they also normally vest over time—that is, the employee can’t exercise or sell his options immediately, but has to wait six months or whatever. There are other ways that this gets more complicated, and I’m sure some of my high-flying techie friends could explain them better than me. :)
Where does the stock come from when someone exercises a stock option?
In my first example—where I sell you an option in Coca Cola—if you decide to exercise that option, then I’m either going to sell you a share of Coca Cola I already own, or I have to go buy the stock on the open market, then sell it to you. (Presumably at a loss, since you’re not likely to exercise the option otherwise).
In the second example—Company X issued the option to an employee—Company X can do the same thing you or I would do if the option is exercise. But Company X is unlikely to sell the employee an existing share of stock. Instead, Company X will simply issue some more stock and sell that. Companies control their stock supply much the same way that countries control their currency—if they need more, they can always print some off.
So, follow the logic here.
Company X gives John 10 stock options. Since the option is just a promise to sell, there’s no exchange of cash involved. Company X hasn’t given John anything but a piece of paper that they printed off.
John exercises those options six months later. He pays Company X $100 to buy ten shares of stock. Once again, Company X just prints off the stock and takes John’s money. Technically, Company X still hasn’t spent any money on this transaction—in fact, they get $100 from John for it. John turns around and sells it on the market for $150, making his profit. John now has $50.00. Company X didn’t give that money to him, right? So where did it come from?
Existing shareholders. It’s their shares which Company X has diluted, and it’s their shares which will go down in value because John sold his. It’s just like the way the US Treasury can’t simply print of billions of dollars to pay off the US debt—that would create massive inflation and destroy the value of the existing currency. And since shareholders are the company, really, Company X is the one who has paid for it. Or, put another way—if Company X hadn’t given those options to John, they could have sold the same ten shares they gave him for a $100 and made the $150 themselves.
Next up: So it this isn’t an expense, what is it?