Describe how a typical stock option plan works. What are some problems with a typical stock option plan?

Explanation

A typical employee stock option is the option provided by a corporation to its employees. The employees stock option is always issued at the money. That is, its strike price is equal to the stock price of the company on the date of the issue. The expiry period of such an option is very long unlike a normal stock option. Usually it is 10 year or more.
 
Thus, the employee has the right to buy the shares of the company during the maturity period. However, there is a vesting period associated with employee stock option plans. It is the locking period, during which the employee cannot exercise the option. Thus, the employee can exercise the option only after the expiry of vesting period.
 
If the option is not exercised during the maturity period, the option gets automatically exercised at the end of the period. This is only if the price of the stock of the company is greater than the strike price. The option is exercised and the employee sells it in the open market, thereby enjoying the profits arising due to difference in stock price and the strike price. However, if the stock price is less than the strike price even at the maturity of the contract period, the option remains unexercised.
 
Problems with a typical stock option plan are as follows:

Stock options are not tradeable in the market. Unlike regular stock options, the employees are not allowed to write the option. Thus, the employee has to wait till the stock price exceeds the strike price and cannot transfer the risk by selling the option.
The inherent benefit of the employee stock option is its availability at no cost. Employees are not charged with option price when the company issues the option. However this incentive can be fruitful if the option is sold in the market. The employee can enjoy the benefit of entire option price, as the original cost of the option is nil

As the employee's stock option cannot be traded in the derivative market, the direct incentive benefit associated with it is wiped. Thus, to get the benefit, the employee needs to exercise the option and then sell the stock in the market.
 

Employees need to remain in the company for a minimum threshold of time to gain the benefit of the employee stock options. When the employee leaves the corporation the employee option ceases to exist.
The employee stock option has the stocks of only a single company. This leads to a less diversified portfolio. The value of the portfolio solely depends on the performance of the company. Thus, the risk element is higher.

Verified Answer

Under the stock option plan, the shares of the company are offered to the employees at a price which is lower than the market price. The option can be exercised by the holders anytime till its fixed expiration date and after that the option lapses.
 
Problems with stock option plan includes:

Employee stock options are not tradable
The loss of incentive if the holders exercise the option before expiration date.
Employees need to remain in the company till exercising the option.
Lack of Diversification.