> 1a) In the market, the owner of a stock can "write" a call option on stock he > owns, meaning a buyer pays the stock owner a market price for the option. > The option buyer is paying for the rights to the future gains from the > stocks, the stock owner giving up rights to the gains.
Well, you can also write "uncovered" options, but you're taking a potentially unlimited risk. > 1b) When a firm pays an employee with stock options, > > A) does the firm in effect write options on stocks held by the firm, or > B) does the firm create options by fiat, based on no shares? > If B, the employee option owner gains at whose expense? I think it can be either. Many companies have share repurchase plans through which they repurchase stock throughout the year. They can then give this stock out to option-exercisers. Alternatively, the stock option program itself (which, I believe, must be approved by shareholders) might allow the company to issue new shares. In B, the company is (pretty much) giving away new shares and diluting the ownership of the current shareholders. This isn't really an expense per se -- handing out more shares has no effect on the profitability of the company, only on per share numbers. > 1c) The true cost to the firm seems to be the market price of the option. > Is this what accountants and reformers say would be charged to expenses? The treatments I've read argue that when I exercise (say) a $10 call option on a $50 stock, that should count as a $40 expense for the company, since they're giving me a share worth $50 for $10. But (see below) this disagrees with GAAP. (tangentially, accounting rules related to market values of options are a nightmare-and-a-half). > 2) When the option is exercised, the option owner pays the exercise price, > which I presume is usually very low. > > a) Does the firm typically issue new shares of stock for this sale, or > b) does the firm sell shares that it buys or previously owned? In my experience it's the former, although many companies will continually buy back shares to offset the dilution. In that case it's almost a matter of semantics. Is the company issuing new shares and then buying (some of them) back? Or are they buying back shares and then handing them out? > If the firm issues new shares or buys shares, it seems this is a second > expense, since issued shares dilute the value of other shares, and bought > shares are an explicit cost. > > Are newly issued shares for options exercised recorded as an expense to the > shareholders? Right, but dilution isn't really an expense. Imagine that my company with 100 outstanding shares of stock suddenly issues 100 more shares to my family. That sucks for the original shareholders, but it doesn't affect the company's profits, so it's not really an expense. My accounting textbook (Meigs & Meigs) says this: Notice that no gain or loss is recognized on treasury stock transactions, even when the shares are reissued at a price above or below cost. A corporation earns profits by selling goods and services to outsiders, not by issuing or reissuing shares of its own capital stock. ... if treasury shares are reissued at a price below cost, the corporation ends up with less paid-in capital as a result of the purchase and reissuance of the shares. Thus any changes in stockholders' equity resulting from treasury stock transactions are recorded as changes in paid-in capital and are not included in the measurement of net income. So even if the company has to pay $50 for a share to settle my $10 call, here's what happens: 1) company buysback share. asset CASH decreases by $50 stockholders equity TREASURY STOCK decreases by $50 2) company reissues share for $10 asset CASH increases by $10 stockholders equity TREASURY STOCK increases by $50 stockholders equity ADDITIONAL PAID-IN CAPITAL decreases by $40. the net effect is asset CASH decreases by $40 stockholders equity ADDITIONAL PAID-IN CAPITAL decreases by $40. -- If the company just issues a new share for $10, then asset CASH increases by $10 stockholders equity COMMON STOCK increases by the par value (say, $1) stockholders equity ADDITIONAL PAID-IN CAPITAL increases by the rest (say, $9) -- That's a lot of accounting mumbo-jumbo (and I'm not really an accountant, so I hope I got it right) but the key idea is that stock issuance/buyback doesn't affect earnings, in this context or in any other. And since the option exercise is just an issuance (possibly preceded by a buyback) it doesn't affect earnings. And I think I've just convinced myself that it shouldn't. :) - Joel
