The Stock Option Problem is a very real concern for every co-owner of a publicly-traded company.  Stock Options are typically granted by Corporate Boards to Manager-Employees; and the Option-grantee managers are often the the same individuals to whom the Board members owe their respective positions. The major problem with management stock options is that they cause shareholder dilution.

Shareholder dilution represents a subtle but very real way of losing money for owners who are not part of a corporation's management. Dilution of pro rata ownership of a firm routinely occurs when a Board of Directors authorizes stock options to its executives (manager-employees).  For example, imagine that the XYZ Corp. has 5,000,000 common shares authorized, and 1,000,000 shares issued and outstanding on January 1st.  Co-owner X (not an employee) holds 100,000 shares and owns 10% of the firm.  On January 2nd the firm issues an additional 50,000 shares, so that Manager Y may exercises a stock option.  At the end of the day, the XYZ Corp. has 1,050,000 shares outstanding; and Co-owner X owns 9.5% of the firm.  The investor's pro rata ownership of the firm was reduced, or diluted.

The Mechanics of Stock Options:
Stock options are granted based on the current market price of a firm's common stock; however, the power to exercise the option may continue for a period of years.  By example, Manager Y may be granted Warrants (today commonly called "stock options") to purchase 10,000 shares of common for up to five years from the Grant Date.  The grant date is the day that the manager-employee comes into possession of the stock option and has the power to exercise it.  The common stock's per share market price is noted on the Grant Date; and it is the Grant Date's market price that controls the per share price that the Option Holder must pay in the future, if the option is exercised.  If the Grant Date is critical on one end of the spectrum, then the Exercise Date is critical at the other end of the spectrum.  The Exercise Date is that day when the Option Holder chooses to exercise the option to purchase common stock.   By example, if the common stock price quadruples from $10 per share on the Grant Date to $40 per share on the Exercise Date (illustratively, three years in the future), then Manager Y has the power to purchase 10,000 shares of common at $10, and immediately turn around and sell those shares at $40 per share (market price of the common on the Exercise Date).  Thus, the manager-employee has the power to pay $100,000 in order to get $400,000 on the same day.  The profit of $300,000 was gained with absolutely no risk incurred by the employee.

Professor Benjamin Graham of Columbia University, mentor to the young Warren Buffett and the father of Value Investing, asserted in the 1934 classic, Security Analysis, that stock option holders take away rights to future claims on business wealth without taking any risks [my emphasis].  That is, as noted below in an illustrative example, for the Stock Option Grantee, there is all upside and no downside (Security Analysis, pg. 550-552).

The Insider's Argument for Stock Options:
A common argument made on behalf of corporate insiders for this arrangement asserts that the common shareholder also would see his or her investment quadruple during the same period.  At first blush, the argument sounds reasonable; however,  the assertion crumbles upon close examination.  Imagine that the non-employee shareholder purchases the common stock on the same day as the Stock Option is granted to the insider-mployee. The non-employee shareholder buys 10,000 shares of XYZ common at $10 per share; on the same day, the insider-employee is granted Warrants for 10,000 common shares of  XYZ at an Exercise Price of $10 per share (market price on Grant Date).  Total cost for the insider-employee: zero dollars and zero cents.  Total cost for the non-employee shareholder: $100,000.  Thus, the non-employee shareholder puts $100,000 of equity capital at risk in an enterprise where the employee puts nothing at risk.   However, if the stock does quadruple, the shareholder will not benefit any more for the risk than the employee who put no capital at risk. 

Addressing the Stock Option Problem:

From a practical standpoint, the solution to shareholder dilution is quite limited.  The best thing that most shareholders, or potential shareholders can do is to vote with their feet.  If possible, vote against the most egregious violations by never purchasing certain companies in the first place.  Stated differently, with a close examination of a corporation's published record, some management teams deserve to be shown the door by the exodus of shareholders because of their egregious behavior.  If they have the power to grant themselves massive loads of stock options, and they exercise that power via their hand chosen Board of Directors, they don't deserve to have others put their equity capital at risk.  Let them scrounge for capital via the debt markets.   

To actually decipher whether the stock option problem is suffocating a firm, you will want to review financial statements from seven, three, and one year ago; and look for a trend.
How have the maximum number of common shares outstanding changed; and how has the book value of the common shares changed over time? If book value is not steadily increasing in a commensurate manner with rising earnings per share, then one of the reasons for this is most likely some form of shareholder dilution.  And the most common shareholder dilution occurs because of the stock option problem.  Bear in mind that, although book value (per share net worth) of a corporation does not indicate its exact market value on any given day, there are only two sources from which shareholders will ever find returns on capital actually flowing into their pcokets: currently paid cash dividends and an increasing reserve fund that could pay cash dividends.  The reserve fund that could pay large, future cash dividends is reflected through the rising per share net worth of a firm.  By example, Warren Buffett's Berkshire Hathaway corporation has failed to pay a quarterly cash dividend since 1967; however, it has built up book value from approximately $19 per share in 1965 to $84,487 at the close of 2009.  Except where legacy issues must be resolved as new acquisitions enter the fold, Berkshire Hathaway does not engage in the stock option game.

In closing, consider these prophetic words for the future of common stock in America:  "Warrants [stock options] are in name and in form, as low-priced stocks are frequently in essence, a long-term call upon the future of the business."
                                                              -- Benjamin Graham and David Dodd, Security Analysis