A "stock option" is a right issued to an individual to buy shares of stock in a given issuer at a fixed or formula price (subject to adjustments) over a stated period of time. It is a "derivative" security in that the option itself derives its value from the value of the underlying stock. An option and a warrant are conceptually the same; an option is a warrant exercisable, usually, by an employee and usually over a longer period. The company itself, usually issues an option, to be satisfied by newly issued shares but such is not necessarily the case. Any owner of stock can sell an option–a "call," in trading parlance–on his stock on whatever terms are mutually agreeable, but the same will not be an "incentive stock option."
To the company planning on issuing the options, there are several events in the process (each of which could be the occasion for a tax of some kind). If the option is to enjoy favorable tax treatment (and perhaps even if it is not), the first step is for the directors to adopt, and the stockholders to ratify, a stock-option plan. Adoption of a plan does not, of and by itself, involve the grant of options to any individuals. The plan, first and most importantly, identifies the maximum number of shares which can be issued to all the recipients in the aggregate; this is usually about 10 percent to 15 percent of the total stock outstanding, depending on the caliber of the employees and the willingness of the investors to dilute. The plan tells the stockholders the maximum amount of dilution they will suffer if all the options are granted and exercised. It also sets out the basic provisions in each option contract, most of which are required under the Code if the options are to be "incentive stock options" under §422.
Options are granted to individuals pursuant to individual contracts. The scope of the plan contemplates the issuance of incentive stock options (ISOs) and/or nonqualified stock options (NSOs) and, perhaps, cash buyouts of the options in lieu of exercise, in the discretion of the issuer or the employee (Stock Appreciation Rights, or SARs). In any event, the options must now comply with Code Section 409A, meaning the exercise price must be established at fair value of the underlying shares upon issuance.