Advice for companies planning to issue stock options.

• Author: James, Glenn

The stock option is by far the most useful long-term incentive an employer can provide to its employees.

Total Plan Shares

Institutional investors (including venture capitalists) have established a "market standard" to limit the total number of options a company should grant its employees and directors. This standard calls for companies to have no more than a 10% stock option "overhang." An overhang percentage is calculated by dividing the number of options available (granted and available to grant) by the sum of the total number of shares outstanding and the number of options available.

Example: A company has 100,000 shares of stock outstanding and adopts an option plan that permits grants of stock options for up to 11,111 shares. The company will have an option overhang of approximately 10% (11,111/(100,000 + 11,111)). The market standard stock option overhang expands to 15% for companies with a smaller market capitalization.

Allocation Between Directors and Employees

Companies must decide how to allocate options between employees and outside directors. Typically, the board of directors sits in an oversight position rather than taking an active role in managing the company's business.

Because the role of outside directors is limited, they typically receive between 10% and 40% of the total number of stock options available, with employees receiving the rest.

Key Employees

More often than not, stock options are best used as a compensation device only for those employees with the greatest potential to significantly affect the company's future financial performance. The main question is whether a prospective grantee can personally affect the company's outcome. If so, the prospect is an acceptable grantee; if not, chances are that another compensation device will work more effectively as a performance incentive.

Broad-based plans work most effectively in a high-tech company in which the average employee has a master's degree in computer science. These plans, therefore, are clearly the exception rather than the rule. In a typical company, granting options to a broad base of employees, in a total amount that satisfies the market standard, serves only to dilute the options' incentive power. The number of options an individual employee receives will not have enough upside potential to provide a meaningful incentive; cash would work better.

Allocating Among Key Employees

In allocating options among key employees, the first step should be to...