When the system works, stock options let managers tie compensation to their company's stock price. Stock options let employees buy shares at a future date based on the strike price, the price of the shares on the date the options were issued. After a vesting period, if the market price of the shares rises, the options are "in the money," letting holders pocket the difference between the strike price and price on the day they sell the shares.
The problem with recently disclosed option-pricing practices is they dilute the performance incentive. Companies have either handed out options priced so low that they were already in the money on the issue date, or they've set the strike price at the lowest point shares traded in a given period. Companies also didn't have to disclose option awards right away. The practices weren't illegal but have been sharply curtailed by the Sarbanes-Oxley Act.
Options Pricing Scandal Could Hit Tech Vendors' Customers