Dilutive Stock Options

Corporate employees use stock options to build their own personal wealth. For outside, non-employee investors, however, the dilutive effect of these very same stock options may translate into lost shareholder value. To understand dilution, it is critical that you study the basics of corporate finance and executive compensation. From there, you can coordinate an effective financial plan, as either an employee or outside investor.

Definition

• Dilutive stock options increase the number of corporate outstanding common shares. Larger numbers of common shares decrease the ownership percentage of each share of stock, which may translate into lost value. For example, Corporation X may report $2 million in earnings alongside 1 million shares of outstanding common stock -- for $2 ($2 million / 1 million shares) in earnings per share.

  Immediately after this report is released, executives exercise dilutive stock options to buy 500,000 shares of stock. Shareholder value is lost, as earnings per share now falls to $1.33 ($2 million / 1.5 million shares).

Exercising Dilutive Stock Options

• Dilutive stock options feature a strike price, where employees can exercise their options to buy stock at that price. For example, dilutive stock options on Corporation X may feature a $50 strike price. These dilutive options carry value only if Corporation X trades for more than $50 in the stock market.

  Value for these options increases alongside higher share prices for the company stock. Managers are therefore likely to devise strategy that supports higher share prices, and their own respective bottom lines.

Warning

• The emphasis on share price through stock option compensation can lead management to develop a short-term mindset at the expense of long-term business stability. For example, managers may spend cash to finance expansion instead of paying down debt. These decisions can improve profits on near-term quarterly reports and stock options, but also create future financial distress for long-term investors.

Dilutive Stock Options and Taxes

• Stock options could be taxed when they are exercised. The difference between option strike price and market value may be treated as income. For example, you may exercise options to buy Corporation X stock at $50, while it trades for $75 in the market. The $25 difference is considered taxable income.

  Employees may pay capital gains taxes as a result of dilutive stock options. If you eventually sell Corporation X stock for $105, you will owe capital gains taxes on $30. This $30 is the difference between current $105 share price and Corporation X market value at the time you exercised options.

Strategy

• As an employee who received a stock option from your employer, you should diversify financially around your stock options. If your employer were to fail, you would not only be out of a job, but you would hold worthless shares and stock options. To diversify, you can exercise options and immediately sell company stock. From there, you can use that cash to buy into stock and bond mutual funds.

  As a non-employee investor, you should target companies that spend cash to purchase their own shares of outstanding common stock and retire them as treasury stock. Stock buy backs reduce the amount of outstanding common stock and counter the effects of dilutive stock options.