The McGraw-Hill 36-Hour Course: Finance for Nonfinancial Managers (McGraw-Hill 36-Hour Courses) by Shoffner H. George & Shelly Susan & Cooke Robert A

Author:Shoffner, H. George & Shelly, Susan & Cooke, Robert A. [Cooke, Robert A.]
Language: eng
Format: epub
Publisher: McGraw-Hill
Published: 2010-12-16T02:00:00+00:00

Using Stock and Stock Options as a Medium of Exchange

Many corporations today have to seek to conserve cash. One way of accomplishing this is to issue stock to suppliers of goods or services, which can be a legitimate cash-saving device if not carried to an extreme. (See the section on dilution that follows.) For instance, a corporation might contract with a lawyer to handle a certain issue for a specific number of shares of stock. The corporation saves cash, and the lawyer receives the stock, which he or she hopes will quickly increase in value. (If the lawyer did not expect an increase in value, there would be little incentive for accepting stock in exchange for services.)

Similarly, a corporation could issue stock to employees in exchange for their services. Inasmuch as most employees want immediate cash for their labors, paying employees with stock usually takes the form of a stock purchase plan or issuance of stock options. What is a stock option? In its most common form, an option allows the holder of the option (the employee) to purchase stock at a specific price sometime in the future. If the market price has risen above the price specified in the option, the employee stands to gain money in addition to the salary he or she was paid. In other words, this allows the employee to share in the good fortune of the employer and can contribute significantly to employee retention.

For instance, after going public, you and Paul decided to hire a CEO to run your company while the two of you spend more time on the golf course. You find Greg, an individual with the management skills and experience needed to run Paul’s Permanent Lawns, Inc. You work out this compensation arrangement for Greg: a salary of $300,000 plus stock options that enable him to buy 400 shares of stock at $2,000 per share at any time within the next five years.* If Greg operates the corporation well and it earns fabulous profits, and the stock market loves the stock and that causes the market value of the stock to increase tenfold to $25,000 per share, Greg is sitting in clover. Specifically, he could exercise his option by buying his 400 shares for $2,000 apiece and selling them for the $25,000 market price. That amounts to his paying $800,000 for 400 shares and selling them for $10 million. If you divide that gain by the five-year life of the option, his annual take from the job is quite respectable. This is a win-win situation: your corporation hired a CEO for a reasonable salary (for CEOs) but at the same time, the CEO was well-compensated.

This does represent a cost to the corporation, or at least to the stockholders, because of the dilution effect covered in the next section. Some people argue that the issuance of stock options represents an expense of the corporation. Others argue that as no cash or other assets of the corporation are spent in the issuing stock

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