Employee stock options ESOs are a type of equity compensation granted by companies to their employees and executives. Rather than granting shares of stock directly, the company gives derivative options on the stock instead. These options come in the form of regular call options and give the employee the right to buy the company's stock at a specified price for a finite period of time. Terms of ESOs will be fully spelled out for an employee in an employee stock options agreement. In general, the greatest benefits of a stock option are realized if a company's stock rises above the exercise price.
The holder may choose to immediately sell the stock in the open market for a profit or hold onto the stock over time. ESOs can have vesting schedules which limits the ability to exercise.
Updated Sep 18, What is a Stock Option?
ESOs are taxed at exercise and stockholders will be taxed if they sell their shares in the open market. Stock options are a benefit often associated with startup companies, which may issue them in order to reward early employees when and if the company goes public.
They are awarded by some fast-growing companies as an incentive for employees internet earnings every day work towards growing the value of the company's shares.
Stock options can also serve as an incentive for employees to stay with the company. The options are canceled if the employee leaves the company before they vest. ESOs do not include any dividend or voting rights. These plans are known for providing financial compensation in the form of stock equity.
Employee Stock Option (ESO)
Other types of equity compensation may include: Restricted Stock Grants: these give employees the right to acquire or receive shares once certain criteria are attained, like working for a defined number of years or meeting performance targets. Employee Stock Purchase Plans: these plans give employees the right to purchase company shares, usually at a discount.
In broad terms, the commonality between all these equity compensation plans is that they give employees and stakeholders an equity incentive to build the company and share in its growth and success.
They receive preferential tax treatment in many cases, as the IRS treats gains on such options as long-term capital gains. Also known as non-statutory stock options, profits on these are considered as ordinary income and are taxed as such. The grantee—also known as the optionee—can be an executive or an employee, while the grantor is the company that employs the grantee.
The vesting period is the length of time that an employee must wait in order to be able to exercise their ESOs.
Why does the employee need to wait? Because it gives the employee an incentive to perform well and stay with the company. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant. Note that the stock may not be fully vested when purchased with an option in certain cases, despite exercise of the stock options, as the company may not want to run the risk of employees making a quick gain by exercising their options and immediately selling their shares and subsequently leaving the company.
If you have received an options grant, you must carefully go through your company's stock options plan, as well as the options agreement, to determine the rights available and restrictions applied to employees. The options agreement will provide the key details of your option grant such as the vesting schedule, how the ESOs will vest, shares represented by the grant, and the strike price.
If you are a key employee or executive, it may be possible to negotiate certain aspects of the options agreement, such as a vesting schedule where the shares vest faster, or a lower exercise price. It may also be worthwhile to discuss the options agreement with your financial planner or wealth manager before you sign on the dotted line. ESOs typically vest in chunks over time at predetermined dates, as set out in the vesting schedule.
As mentioned earlier, we had assumed that the ESOs have a term of 10 years. This means that after 10 years, you would no longer have the right to buy shares.
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- Objectives[ edit ] Many companies use employee stock options plans to retain, reward, and attract employees,  the objective being to give employees an incentive to behave in ways that will boost the company's stock price.
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Therefore, the ESOs must be exercised before the year period counting from the date of the option grant is up. It should be emphasized that the record price for the shares is the exercise price or strike price specified in the options agreement, regardless of the actual market price of the stock. A reload option is a nice provision to take advantage of.
As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread. The grantee or optionee is not faced with an immediate tax liability when the options are granted by the company.
Taxation begins at the time of exercise. The sale of the acquired stock triggers another taxable event.
The Pay-to-Performance Link
If the employee sells the acquired shares for less than or up to one year after exercise, the transaction would be treated as a short-term capital gain and would be taxed at ordinary income tax rates. If the acquired shares are sold more than one year after exercise, it would qualify for the lower capital gains tax rate. This spread is taxed as ordinary income in your hands in the year of exercise, even if you do not sell the shares.
This aspect can give rise to the risk of a huge tax liability, if you continue to hold the stock and it plummets in value. The ability to buy shares at a significant discount to the current market price a bargain price, in other words is viewed by the IRS as part of the total compensation package provided to you by your employer, and is therefore taxed at your income tax rate. Thus, even if you do not sell the shares acquired pursuant to your ESO exercise, you trigger a tax liability at the time of exercise.
Time value depends on the amount of time remaining until expiration the date when the ESOs expire and several other variables.
The Downside Risk
Given that most ESOs have a stated expiration date of up to 10 years from the date of option grant, their time value can be quite significant. While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them.
To calculate the time value for your ESOs, you would have to use a theoretical pricing model like the well-known Black-Scholes option pricing model to compute the fair value of your ESOs.
You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO.
From there, it is a simple exercise to calculate time value, as can be seen below. The exercise of an ESO will capture intrinsic value but usually gives up time value assuming there is any leftresulting in a potentially large hidden opportunity cost. Consider a situation where your ESOs are out of the money i.
Comparisons to Listed Options The biggest and most obvious difference between ESOs and listed options is that ESOs are not traded on an exchange, and hence do not have the many benefits of exchange-traded options. The Value of Your ESO Is not Easy to Ascertain Exchange-traded options, especially on the biggest stock, have a great deal of liquidity and trade frequently, so it is easy to estimate the value of an option portfolio.
Not so with your ESOs, whose value is not as easy to ascertain, because there is no market price reference point. Many ESOs are granted with a term of 10 years, but there are virtually no options that trade for that length of time.
Option pricing models are therefore crucial for you to know the value of your ESOs. Your employer is required—on the options grant what is a stock option specify a theoretical price of your ESOs in your options agreement.
Be what is a stock option to request this information from your company, and also find out how the value of your ESOs has been determined. Option prices can vary widely, depending on the assumptions made in the input variables. For example, your employer may make certain assumptions about expected length of employment and estimated holding period before exercise, which could shorten the time to expiration. With listed options, on the other hand, the time to expiration is specified and cannot be arbitrarily changed.
Assumptions about volatility can also have a significant impact on option prices. If your company assumes lower than normal levels of volatility, your ESOs would be priced lower. Specifications Are not Standardized Listed options have standardized contract terms with regard to what is a stock option of shares underlying an option contract, expiration what is a stock option, etc.
This uniformity makes it easy to trade options on any optionable stock, whether it is Apple trading robots disadvantages Google or Qualcomm.
If you trade a call option contract, for instance, you have the right to buy shares of the underlying stock at the specified strike price until expiration. Similarly, a put option contract gives you the right to sell shares of the underlying stock until expiration. While ESOs do have similar rights to listed options, the right to buy stock is not standardized and is spelled out in the options agreement. No Automatic Exercise For all listed options in the U.
If the third Friday happens to fall on an exchange holiday, the expiration date moves up by a day to that Thursday. Thus, if you owned one what is a stock option option contract and at expiration, the market price of the underlying stock was higher than the strike price by one cent or more, you would own shares through the automatic exercise feature.
Likewise, if you owned a put option and at expiration, the market price of the underlying stock was lower than the strike price by one cent or more, you would be short shares through the automatic exercise feature.
Note that despite the term "automatic exercise," you still have control over the eventual outcome, by providing alternate instructions to your broker that take precedence over any automatic exercise procedures, or by closing out the position prior to expiration. With ESOs, the exact details about when they expire may differ from one company to the next. Also, as there is no automatic exercise feature with ESOs, you have to notify your employer if you wish to exercise your options.
With ESOs, since the strike price is typically the stock's closing price on a particular day, there are no standardized strike prices. In the mids, an options backdating scandal in the U. This practice involved granting an option at a previous date instead of the current date, thus setting the strike price at a lower price than the market price on the grant date and giving an instant gain to the option holder.
Options backdating has become much more difficult since the introduction of Sarbanes-Oxley as companies are now required to report option grants to the SEC within two business days. ESOs may require the employee to attain a level of seniority or meet certain performance targets before they vest. If the vesting criteria are not crystal clear, it may create a murky legal situation, especially if relations sour between the employee and employer. As well, with listed options, once you exercise your calls and obtain the stock you can dispose of it as soon as you wish without any restrictions.
However, with acquired stock through an exercise of ESOs, there may be restrictions that prevent online trading binary options from selling the stock.
- Stock options were just a footnote.
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- Employee Stock Option (ESO) Definition
- The strike price may be set by reference to the spot price market price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium.
Even if your ESOs have vested and you can exercise them, the acquired stock may not be vested. This what is a stock option pose a dilemma, since you may have already paid tax on the ESO Spread as discussed earlier and now hold a stock that you cannot sell or that is declining.
Counterparty Risk As scores of employees discovered in the aftermath of the s dot-com bust when numerous technology companies went bankrupt, counterparty risk is a valid issue that is hardly ever considered by those who receive ESOs. With listed options in the U. S, the Options Clearing Corporation serves as the clearinghouse for options contracts and guarantees their performance. But as the counterparty to your ESOs is your company, with no intermediary in between, it would be prudent to monitor its financial situation to ensure that you are not left holding valueless unexercised options, or even worse, what is a stock option acquired stock.
Concentration Risk You can assemble a diversified options portfolio using listed options but with ESOs, you have concentration risk, since all your options have the same underlying stock.
In addition to your ESOs, if you also have a significant amount of the best options strategies stock in your employee stock ownership plan ESOPyou may unwittingly have too much exposure to your company, a concentration risk that has been highlighted by FINRA.
Understanding the interplay of these variables—especially volatility and time to expiration—is crucial for making informed decisions about the value of your ESOs. Since we assume this is an at-the-money option, its entire value consists of time value. The first table demonstrates two fundamental options pricing principles: Time value is a very important component of options pricing.
Option time decay is not linear in nature. The value of options declines as the expiration date approaches, a phenomenon known as time decay, but this time decay is not linear in nature and accelerates close to option expiry. An option that is far out-of-the-money will decay faster than an option that is at the money, because the probability of the former being profitable is much lower than that of the latter. This increase in volatility has a significant effect on option prices.
Similar results are obtained by changing the variables to levels that prevail at present. In this section, we use the common year grant term to expiration to demonstrate the risk and reward associated with owning ESOs. As your exercise price and the stock price are the same, this is an at-the-money option.