Why give stock options rather than stock? Federal Document Clearing House (FDCH), an electronic publisher of news and information, found out by trial and error. The privately held company, which has more than $1 million in sales and offices in Washington, D.C., and Boston, used to give key employees nonvoting stock periodically. But the arrangement placed a potential tax burden on employees.

"Since our company is growing rapidly, our stock has also become more valuable," managing director Jim Ellis explains. "That meant we were saddling our employees with a tax liability each time we made them a gift." Under the strategically designed stock option plan the company implemented in 1997, taxes become an issue only when employees exercise the options. Plus, the option plan includes rules regarding employee departures and a three-year vesting schedule to discourage turnover.

While there are different types of stock option plans, they all give participating employees the right to buy stock in the company within a certain time frame at a specified price. In privately held companies, stock option plans are most often used when a company expects to go public someday or to be acquired, notes Jim Scannella, a principal in Arthur Andersen's human capital services group.

If you do install an option plan, educating your employees is key, as entrepreneur Doug Mellinger discovered. "They just didn't understand." That's how Mellinger, founder and former CEO of PRT Group, a financial services software developer that had 1998 sales of $85.6 million, describes his employees' initial reaction to the stock option program in the then-private company. During a business trip with an employee of the New York City-based firm, the employee told Mellinger that options in the company "weren't worth very much" because their purchase ("strike") price was so high -- $56 a share. The employee felt he could find countless stocks at lower prices and hence could buy many more shares in those other companies.

Mellinger was stunned. Knowing that PRT had a mere 1.2 million shares outstanding, he tried to explain the difference between price and value. PRT was a company full of paper millionaires who hadn't even bothered to read the documents outlining the option program. "I realized this was a very pervasive problem," Mellinger recalls. "We found that we had very senior executives who had no idea how the program worked." And Mellinger has discovered that PRT's situation was fairly common: "Most of the companies I've met have had the same problems I've had," he says. Before taking PRT public, Mellinger instituted an education program to explain to employees how the stock was valued and how stock options work.