(FORTUNE Magazine) – All those stock options floating around Silicon Valley have long been considered the perfect motivator for a hungry, creative work force. But recently some acute observers have reflected on the downside of the options culture. J. William Gurley, the Internet analyst at DMG Grenfell's Silicon Valley headquarters, writes Above the Crowd, an online column that examines industry trends and dispels hype. Here's an adaptation of his recent look at the options culture:

Way back in 1991, we used to worry that the engineer was underappreciated. Back then, the majority of the bonus money at high-tech firms went to upper management. While executives are undoubtedly valuable, the contribution of key engineers was not recognized with sufficient rewards. In part, the fault lay with the engineers themselves: They seemed to lack the chutzpah to look around.

That was then, and this is now. The incredible bull market of the past six years has been particularly kind to the Silicon Valley common man. Technology firms are much more liberal with stock options than your average public company. So as stock prices have soared, the real compensation of the high-tech working class has become dramatically higher than its base salary. According to Intel's president, Craig Barrett, the average Intel employee received 33% above his base pay in stock option value in 1996. At Cisco Systems and Ascend Communications, the number of employees whose net worth has moved north of seven digits represents a significant portion of the work force. Engineers at smaller outfits have also benefited. Consider Siebel Systems, which went public last June. According to the New York Times Syndicate, a full one-third of the company's 220 employees are already millionaires.

So the worker's interest is now aligned with the shareholder's. Perfect capitalism in action, right? Perhaps. In truth, stock options are a double-edged sword. What builds you up can also bring you down.

The main problem with stock options is that they do not represent true ownership. While the option holder is entitled to all the glory that comes with upward price movements, he is protected from the downside of disappointment. This can have two negative effects. First, there is a huge incentive for option holders to take undue risk. Second, and perhaps more important, there is an incentive for engineers to roam around. Try your luck at one job, and if the company's stock is stuck in the doldrums, move on. After all, who cares about base pay? Engineers are all searching for home runs now, and loyalty is dead in Silicon Valley.

Wall Street needs to look more closely at this liberation of the engineer. An aggressive stock-option program has many of the same characteristics as leverage. When times are good, they are doubly good, and everyone frolics in above-average returns. Shareholders don't care about dilution because the stock's outrageous good fortune more than makes up for it. But when times turn bad, the effects of the stock-option culture can be devastating. In Silicon Valley, options in the bull market have often accounted for 40% of an employee's total compensation. That means that companies with lackluster stock performance are seriously underpaying their employees.

The result of this pseudo-leverage is an interesting application of increasing return economics. Firms that are doing well have increasing stock prices and can therefore attract topnotch employees. Firms that are experiencing difficulty are likely to have trouble keeping the exit doors closed. With unemployment as low as it is in the Valley, jumping ship makes infinite sense. As troubled firms like Apple and Sybase attempt to reorganize, keeping the best engineers is more than difficult.

When considering new investments, investors may want to start paying attention to company location. If stock prices continue to fall, some employees at high-tech companies may earn 30% less than last year's remarkable compensation. These are individuals who have grown accustomed to a certain level of personal wealth. Unfortunately, their mortgages are not particularly malleable; overly optimistic engineers may have trouble making house payments that seemed quite insignificant last year. Moreover, companies trying to recruit employees to the Valley may find the relative cost of living to be a major impediment. Tech companies in places like Boulder, Colorado, and Austin, Texas, may suddenly become more attractive.

We would argue that managers need to address this problem by taking more responsibility for their valuation. Venture capitalists and employees at a young company that goes public are enthralled by a lofty valuation. A P/E ratio of, say, 100 generates buzz in the press and gives employees tantalizing visions of inordinate wealth just around the corner. We recognize that no executive can control the ups and downs of this volatile market. But managers need to tell both employees and investors that such a P/E ratio is unsustainable. They need to make clear that at some point, once a company has graduated past the stage of youthful exuberance, its stock price will be based on something more real than ultimate potential--it will start to reflect expectations of near-term earnings. Managers could do worse than point to Microsoft, whose employees have done pretty well for themselves despite the fact that the company generally trades at a mere 30 or 40 times earnings and is highly unlikely to exceed those ratios.

If, on the other hand, managers choose to sustain the hype and bombast, they'll soon find that their best employees, disappointed by a flagging stock price, will take flight. And investors, who once rallied around what seemed like an exciting prospect, will soon be gone as well.