Employee stock option
From Wikicpa
Employee stock options are stock options for the company's own stock that are often offered to upper-level employees as part of the executive compensation package, especially by United States corporations. An employee stock option is identical to a call option on the company's stock, with some extra restrictions.
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Mechanics
The company gives a stock option grant to the employee which specifies:
- The number of options granted to the employee
- The options' exercise price
- The options' expiration date
- The options' vesting schedule, specifying when options may first be exercised
- A list of restrictions on what can and can't be done with the options
For example, when employed by company XYZ, Alex might receive a stock option grant of 1000 XYZ shares, with an exercise price of $7.50, an expiration date of 10 years after the grant, and a schedule of equal vesting over four years.
The exercise price is typically set at the company's stock price on the day of the option grant. Hence, moving forward, the employee can make money if the stock price rises, and will not make money if, instead, the stock price drops. Some companies, such as IBM as of 2004, set the exercise price to be slightly higher than the current stock price, partially to deter criticism that option grants are too expensive a price for the stockholders to pay.
As with an ordinary call option, Alex can make money if the price of XYZ stock rises above his exercise price of $7.50 before the options expire. Suppose that 5 years after the option grant, the price of XYZ has risen to $16.00. Alex decides to exercise all 1000 options. The stockbroker managing Alex's option account pays company XYZ $7,500 ($7.50 per option times 1000 shares) and receives the 1000 shares. (In doing this, the stockbroker is extending Alex a very short-term loan of $7,500.) The stockbroker immediately sells the 1000 shares on the stock market and receives $16,000. The stockbroker then deducts the $7,500 he advanced for the options exercise, and the remaining $8,500 belongs to Alex, after the stockbroker deducts his commission and fees.
The vesting schedule controls when Alex may exercise his options. In this example, his 1000 options vest equally over four years, so Alex could exercise 250 of his options one year after the option grant, an additional 250 options after one additional year, and so on. Unvested options are not available to exercise, and options only continue to vest so long as Alex is an employee.
Rationale for stock option grants
The usual rationale given for stock option grants to employees is to "align employees' interests with the interests of stockholders". If the company's stock rises, its employees with stock options experience a direct financial benefit; this, the argument goes, will give employees incentives to always behave in a way that will boost the company's stock. This is supposed to increase productivity and increase vigilance for such things as corporate waste.
Simply granting stock, rather than options, would achieve this same effect, but this would cause a more immediate dilution of stockholders' equity, and would usually give away some voting rights (which option holders do not have).
A benefit to the company's managers is that if options are exercised and employees make money, this is not an actual cash outlay by the company; rather, the money effectively is paid by the current stockholders, in the form of dilution. For example, if the company issues an extra 1000 shares of stock when an employee exercises his options, the company's value is now spread across an additional 1000 shares, so all the company's shares are made to have a slightly lower value.
Stock options are sometimes jokingly referred to as "golden handcuffs" (in the same vein as golden handshakes or golden hellos), especially in a strongly rising market - the employee may feel compelled to work out the time until they are able to liquidate the stock even if they might otherwise prefer to leave the company. During the dot-com boom, many employees' compensation consisted largely of stock options; there are cases in which secretaries and janitors became multi-millionaires after their companies went public.
Some critics of employee stock options, such as Warren Buffett, have argued that stock options do not align optionholders' interests with those of stockholders, as executives don't experience the same pain that stockholders do if the share price drops (if the option becomes worthless, the option holder is no worse off than before); that the purported incentive to employees can disappear completely if the company's stock price drops to a certain point below the optionholders' exercise price; that options are given away too freely without sufficient regard to the dilution suffered by stockholders; and that companies sometimes unwisely spend money on a stock repurchase in order to reverse the dilution caused by the exercise of options.
Restrictions and other differences from call options
Employee stock options differ from ordinary call options that are traded on exchanges as securities primarily in the time frame under which they can be exercised. Employee stock options typically allow an exercise time frame of up to ten years, whereas the longest time to expiry for exchange-traded options is typically 2 years. Thus employee stock options are similar to warrants.
There are typically a number of restrictions on employee stock options:
- The options vest over several years. An employee is able to exercise a few more options each year until all his options have vested, at which point he may exercise them all, until they expire.
- Employee stock options are not transferable; they cannot be sold to any other party. Whereas call options may be sold to another party, the only way to make money with employee stock options is to exercise them. The one typical exception is that in the event of the death of the employee, the spouse inherits all the vested options.
- For companies that are not publicly traded, the options are typically not exercisable (and therefore worth nothing) until the company is either acquired or goes public with an IPO.
Types of Employee Stock Options in the United States
In the U.S., stock options granted to employees are of two forms, that differ primarily in their tax treatment. They may be either:
- Incentive stock options (ISOs)
- Non-qualified stock options (NQSOs)
Expensing of Employee Stock Options
According to US generally accepted accounting principles in effect before June 2005, stock options granted to employees did not need to be charged as an expense on the income statement when granted, although the cost was disclosed in the notes to the accounts. This allows a potentially large form of employee compensation to not show up as an expense in the current year, and therefore, currently overstate income. Many assert that over-reporting of income by methods such as this by American corporations was one contributing factor in the Stock Market Downturn of 2002.
Many people argue that stock options should not be treated as an expense. Every other expense decreases the net worth of the corporation, whereas stock options, when exercised, actually increase it. Exercised stock options do not lower the income of the corporation, but "cut more slices into the pie" of earnings per share. Those who are against stock option expensing say that the diluted earnings per share metric (the amount of income divided by all outstanding shares and all shares that would theoretically exist if all the stock options were used) clearly shows the economic effect of stock options. For example, Martin J. Whitman argues that while stock options may dilute the value held by each of a company's existing shareholders, they are of little concern to creditors, and that "GAAP (generally accepted accounting principles) ought to be geared toward meeting the needs and desires of creditors rather than the needs and desires of short-term stock market speculators." [Martin J. Whitman, Third Avenue Value Fund Letters to our Shareholders July 31, 2004
Employee stock options have to be expensed under US GAAP (generally accepted accounting principles) in the US. Each company must begin expensing stock options no later than the first reporting period of a fiscal year beginning after June 15th, 2005. As most companies have fiscal years that are calendars, for most companies this means beginning with the first quarter of 2006. As a result, companies that have not voluntarily started expensing options will only see a P&L effect in fiscal year 2006. Companies will be allowed, but not required, to restate prior-period results after the effective date. This will be quite a change versus before, since options did not have to be expensed in case the exercise price was at or above the stock price (intrinsic value based method APB 25). Only a comment in the footnotes was required. Intentions from the international accounting body IASB indicate that similar treatment will follow internationally.
Method of option expensing: SAB 107, issued by the SEC, does not specify a preferred valuation model, but 3 criteria must be met when selecting a valuation model: The model 1) is applied in a manner consistent with the fair value measurement objective and other requirements of FAS123R; 2) is based on established financial economic theory and generally applied in the field; and 3) reflects all substantive characteristics of the instrument (i.e. assumptions on volatility, interest rate, dividend yield, etc. need to be specified). As a result, the vast majority of the Dow Jones companies announced in their 2004 annual report to use the Black-Scholes valuation model to value option grants, as it is the most widely used, best understood method and its assumptions can be made very explicit. This will also make it unlikely that companies significantly understate the value of employee stock options. Only a few companies use other permitted fair-value methods. Black-Scholes and other methods have been heavily criticized for overstating cost (especially by the companies that don’t want to expense options). To address this, FAS 123 has made adjustments which remedy some weaknesses like black-out periods and the fact that not all options will be exercised due to employees leaving.
Taxation of employee stock options in the USA
Because most employee stock options are nontransferrable, are not immediately exercisable, and have other restrictions, the IRS considers that their "fair market value" cannot be "readily determined", and therefore "no taxable event" occurs when an employee receives an option grant. Depending on the type of option granted, the employee may or may not be taxed upon exercise. Non-qualified stock options (those most often granted to employees) are taxed upon exercise. Incentive stock options are not, assuming that the employee complies with certain additional requirements. Most importantly, shares acquired upon exercise must be held for at least one year after the date of exercise. If any of the additional requirements are not fulfilled, there is a "disqualifying dispositon" and the gain realized upon exercise is taxed as ordinary income.
