As long as the firm’s stock keeps going up and it keeps giving out options, this process continues. More options are exercised, tax deductions are taken, and the firm saves cash by lowering its tax bill. But what happens if the stock takes a tumble? Many people’s options will be worthless—their exercise prices will be higher than the market price—and, consequently, fewer options will be exercised. Fewer options are now exercised, the company’s tax deduction gets smaller, and it has to pay more taxes than before, which means lower cash flow.
