The purpose of incentive schemes for executives is to align their objectives with those of the owners of the company; this is what people refer to as solving the principal-agent problem. In a company, shareholders are principals and managers are agents. The main argument in favour of stock option plans is that they give executives a greater incentive to act in the interests of shareholders by providing a direct link between realized compensation and company stock-price performance. In addition, offering employee stock options in lieu of cash compensation allows companies to attract highly motivated and entrepreneurial employees, and also lets companies obtain employment services without (directly) expending cash. Options are typically structured so that only employees who remain with the firm can benefit from them, thus also providing retention incentives.
Finally, stock options encourage executive risk taking, which can mitigate problems with executive risk aversion. Other types of schemes are intended either for different types of employees or to encourage different kinds of behaviours. There are some times when stock options do not work as incentives for employees. This happens when the employee cannot, through their performance, influence the performance of the company as a whole and therefore cannot influence the stock-price. In these cases other incentive schemes may be more appropriate.
Since the late 1980's more and more people have been given the opportunity to purchase stock options. As of 2001, ten million employees have chosen to purchase stock options. Another survey established that 97 of the top 100 e-commerce companies gave the choice of options this year. For these reasons, it is important to understand what stock options are, the different types of options, and their ...
The most common are bonuses. Bonuses are generally related to some measure of performance. It can be divisional performance, department performance, individual performance, sales, etc. The main problem with this kind of incentives is that it may tempt the employee to manipulate results at the end of the year so that he or she can reach the threshold needed for the bonus. There are other differences between stock-options and other incentive schemes which is also important to consider. When a company grants an option to an employee, it bears an economic cost equal to what an outside investor would pay for the option.
But it bears no accounting charge and incurs no outlay of cash. Furthermore, when the option is exercised, the company (usually) issues a new share to the executive, and receives a tax deduction for the spread between the stock price and the exercise price. These factors make the “perceived cost” of an option much lower than the economic cost and therefore are (usually) preferred. The Trouble with Stock Options, Brian J. Hall, Harvard Business School and NBER.