Employee stock option

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An employee stock option (ESO) is a label that refers to compensation contracts between an employer and an employee that carries some characteristics of financial options.

Contents

Employee stock options are commonly viewed as a complex call option on the common stock of a company, granted by the company to an employee as part of the employee's remuneration package. [1] Regulators and economists have since specified that ESOs are compensation contracts.

Call option company

A call option, often simply labeled a "call", is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial instrument from the seller of the option at a certain time for a certain price. The seller is obligated to sell the commodity or financial instrument to the buyer if the buyer so decides. The buyer pays a fee for this right. The term "call" comes from the fact that the owner has the right to "call the stock away" from the seller.

Stock financial instrument

The stock of a corporation is all of the shares into which ownership of the corporation is divided. In American English, the shares are commonly known as "stocks". A single share of the stock represents fractional ownership of the corporation in proportion to the total number of shares. This typically entitles the stockholder to that fraction of the company's earnings, proceeds from liquidation of assets, or voting power, often dividing these up in proportion to the amount of money each stockholder has invested. Not all stock is necessarily equal, as certain classes of stock may be issued for example without voting rights, with enhanced voting rights, or with a certain priority to receive profits or liquidation proceeds before or after other classes of shareholders.

Remuneration is the pay or other compensation provided in exchange for an employee's services performed. A number of complementary benefits in addition to pay are increasingly popular remuneration mechanisms. Remuneration is one component of reward management.

These nonstandard contracts exist between employee and employer, whereby the employer has the liability of delivering a certain number of shares of the employer stock, when and if the employee stock options are exercised by the employee. The contract length varies, and often carries terms that may change depending on the employer and the current employment status of the employee. In the United States, the terms are detailed within an employer's "Stock Option Agreement for Incentive Equity Plan [2] ". Essentially, this is an agreement which grants the employee eligibility to purchase a limited amount of stock at a predetermined price. The resulting shares that are granted are typically restricted stock. There is no obligation for the employee to exercise the option, in which case the option will lapse.

Restricted stock, also known as letter stock or restricted securities, is stock of a company that is not fully transferable until certain conditions (restrictions) have been met. Upon satisfaction of those conditions, the stock is no longer restricted, and becomes transferable to the person holding the award. Restricted stock is often used as a form of employee compensation, in which case it typically becomes transferrable ("vests") upon the satisfaction of certain conditions, such as continued employment for a period of time or the achievement of particular product-development milestones, earnings per share goals or other financial targets. Restricted stock is a popular alternative to stock options, particularly for executives, due to favorable accounting rules and income tax treatment.

AICPA's Financial Reporting Alert describes these contracts as amounting to a "short" position in the employer's equity, unless the contract is tied to some other attribute of the employer's balance sheet. To the extent the employer's position can be modeled as a type of option, it is most often modeled as a "short position in a call." From the employee's point of view, the compensation contract provides a conditional right to buy the equity of the employer and when modeled as an option, the employee's perspective is that of a "long position in a call option."

Objectives

Many companies use employee stock options plans to retain, reward, and attract employees, [3] the objective being to give employees an incentive to behave in ways that will boost the company's stock price. The employee could exercise the option, pay the exercise price and would be issued with ordinary shares in the company. As a result, the employee would experience a direct financial benefit of the difference between the market and the exercise prices.

Stock options are also used as golden handcuffs if their value has increased drastically. An employee leaving the company would also effectively be leaving behind a large amount of potential cash, subject to restrictions as defined by the company. These restrictions, such as vesting and non-transferring, attempt to align the holder's interest with those of the business shareholders.

Golden handcuffs, a phrase first recorded in 1976, refers to financial allurements and benefits that have the objective to encourage highly compensated employees to remain within a company or organization instead of moving from company to company. Golden handcuffs come in different forms, such as employee stock options, which endow only when the employee has been with the company or organization for a certain number of years, and contractual agreements, consisting of bonuses or other forms of benefits which must be repaid to the company if the employee leaves before the date agreed on. Golden handcuffs are frequently used for jobs that require rare and specialised skills or in a "tight labor market", where jobs are more common than workers. In any case, although they are very expensive, they are usually less expensive than the cost to replace a particular employee. Golden handcuffs often receive scrutiny from shareholders and directors.

In law, vesting is to give an immediately secured right of present or future deployment. One has a vested right to an asset that cannot be taken away by any third party, even though one may not yet possess the asset. When the right, interest, or title to the present or future possession of a legal estate can be transferred to any other party, it is termed a vested interest.

A shareholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders may be referred to as members of a corporation. Legally, a person is not a shareholder in a corporation until their name and other details are entered in the corporation's register of shareholders or members.

Another substantial reason that companies issue employee stock options as compensation is to preserve and generate cash flow. The cash flow comes when the company issues new shares and receives the exercise price and receives a tax deduction equal to the "intrinsic value" of the ESOs when exercised.

Employee stock options are offered differently based on position and role at the company, as determined by the company. Management typically receives the most as part of their executive compensation package. ESOs may also be offered to non-executive level staff, especially by businesses that are not yet profitable, insofar as they may have few other means of compensation. Alternatively, employee-type stock options can be offered to non-employees: suppliers, consultants, lawyers and promoters for services rendered.

Executive compensation or executive pay is composed of the financial compensation and other non-financial awards received by an executive from their firm for their service to the organization. It is typically a mixture of salary, bonuses, shares of or call options on the company stock, benefits, and perquisites, ideally configured to take into account government regulations, tax law, the desires of the organization and the executive, and rewards for performance.

Features

Overview

Over the course of employment, a company generally issues employee stock options to an employee which can be exercised at a particular price set on the grant day, generally a public company's current stock price or a private company's most recent valuation, such as an independent 409A valuation [4] commonly used within the United States. Depending on the vesting schedule and the maturity of the options, the employee may elect to exercise the options at some point, obligating the company to sell the employee its stock shares at whatever stock price was used as the exercise price. At that point, the employee may either sell public stock shares, attempt to find a buyer for private stock shares (either an individual, specialized company [5] , or secondary market), or hold on to it in the hope of further price appreciation.

Contract differences

Employee stock options may have some of the following differences from standardized, exchange-traded options:

Valuation

As of 2006, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) agree that the fair value at the grant date should be estimated using an option pricing model. Via requisite modifications, the valuation should incorporate the features described above. Note that, having incorporated these, the value of the ESO will typically "be much less than Black–Scholes prices for corresponding market-traded options...." [12] Here, in discussing the valuation, FAS 123 Revised (A15) - which does not prescribe a specific valuation model - states that:

a lattice model can be designed to accommodate dynamic assumptions of expected volatility and dividends over the option’s contractual term, and estimates of expected option exercise patterns during the option’s contractual term, including the effect of blackout periods. Therefore, the design of a lattice model more fully reflects the substantive characteristics of a particular employee share option or similar instrument. Nevertheless, both a lattice model and the Black–Scholes–Merton formula, as well as other valuation techniques that meet the requirements … can provide a fair value estimate that is consistent with the measurement objective and fair-value-based method….

The reference to "contractual term" requires that the model incorporates the effect of vesting on the valuation. As above, option holders may not exercise their option prior to their vesting date, and during this time the option is effectively European in style. "Blackout periods", similarly, requires that the model recognizes that the option may not be exercised during the quarter (or other period) preceding the release of financial results (or other corporate event), when employees would be precluded from trade in company securities; see Insider trading. During other times, exercise would be allowed, and the option is effectively American there. Given this pattern, the ESO, in total, is therefore a Bermudan option. Note that employees leaving the company prior to vesting will forfeit unvested options, which results in a decrease in the company's liability, and this too must be incorporated into the valuation.

The reference to "expected exercise patterns" is to what is called "suboptimal early exercise behavior". [13] Here, regardless of theoretical considerations − see Rational pricing #Options — employees are assumed to exercise when they are sufficiently "in the money". This is usually proxied as the share price exceeding a specified multiple of the strike price; this multiple, in turn, is often an empirically determined average for the company or industry in question (as is the rate of employees exiting the company). "Suboptimal", as it is this behavior which results in the reduction in value relative to Black-Scholes.

The preference for lattice models is that these break the problem into discrete sub-problems, and hence different rules and behaviors may be applied at the various time/price combinations as appropriate. (The binomial model is the simplest and most common lattice model.) The "dynamic assumptions of expected volatility and dividends" (e.g. expected changes to dividend policy), as well as of forecast changes in interest rates (as consistent with today's term structure), [13] may also be incorporated in a lattice model; although a Finite difference model would be more correctly (if less easily) applied in these cases. [14]

Black-Scholes may be applied to ESO valuation, but with an important consideration: option maturity is substituted with an "effective time to exercise", reflecting the impact on value of vesting, employee exits and suboptimal exercise. [15] For modelling purposes, where Black-Scholes is used, this number is (often) estimated using SEC Filings of comparable companies. For reporting purposes, it can be found by calculating the ESO's Fugit , “the (risk-neutral) expected life of the option", directly from the lattice, [16] or back-solved such that Black-Scholes returns a given lattice-based result (see also Greeks (finance) #Theta).

The Hull-White model (2004) is widely used, [17] while the work of Carpenter (1998) is acknowledged as the first attempt at a "thorough treatment"; [18] see also Rubinstein (1995). These are essentially modifications of the standard binomial model (although may sometimes be implemented as a Trinomial tree). See below for further discussion, as well as calculation resources. Although the Black–Scholes model is still applied by the majority of public and private companies,[ citation needed ] through September 2006, over 350 companies have publicly disclosed the use of a (modified) binomial model in SEC filings.[ citation needed ] Often, the inputs to the pricing model may be difficult to determine [15] — usually stock volatility, expected time to expiration, and relevant exercise multiples — and a variety of commercial services are now offered here.

Accounting and taxation treatment

General accepted accounting principles in the United States (GAAP)

The US GAAP accounting model for employee stock options and similar share-based compensation contracts changed substantially in 2005 as FAS123 (revised) began to take effect. According to US generally accepted accounting principles in effect before June 2005, principally FAS123 and its predecessor APB 25, stock options granted to employees did not need to be recognized as an expense on the income statement when granted if certain conditions were met, although the cost (expressed under FAS123 as a form of the fair value of the stock option contracts) was disclosed in the notes to the financial statements.

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.

Employee stock options have to be expensed under US GAAP in the US. Each company must begin expensing stock options no later than the first reporting period of a fiscal year beginning after June 15, 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 an income statement 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 disclosure in the footnotes was required. Intentions from the international accounting body IASB indicate that similar treatment will follow internationally.

As above, "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 is applied in a manner consistent with the fair value measurement objective and other requirements of FAS123R; is based on established financial economic theory and generally applied in the field; and reflects all substantive characteristics of the instrument (i.e. assumptions on volatility, interest rate, dividend yield, etc.) need to be specified.

Taxation

Most employee stock options in the US are non-transferable and they are not immediately exercisable although they can be readily hedged to reduce risk. Unless certain conditions are satisfied, 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. For a stock option to be taxable upon grant, the option must either be actively traded or it must be transferable, immediately exercisable, and the fair market value of the option must be readily ascertainable. [19] 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 as standard income. Incentive stock options (ISO) are not but are subject to Alternative Minimum Tax (AMT), assuming that the employee complies with certain additional tax code requirements. Most importantly, shares acquired upon exercise of ISOs must be held for at least one year after the date of exercise if the favorable capital gains tax are to be achieved. However, taxes can be delayed or reduced by avoiding premature exercises and holding them until near expiration day and hedging along the way. The taxes applied when hedging are friendly to the employee/optionee.

The Sharesave scheme is a tax-efficient employee stock option program in the United Kingdom.

Excess tax benefits from stock-based compensation

This item of the profit-and-loss (P&L) statement of companies' earnings reports is due to the different timing of option expense recognition between the GAAP P&L and how the IRS deals with it, and the resulting difference between estimated and actual tax deductions.

At the time the options are awarded, GAAP requires an estimate of their value to be run through the P&L as an expense. This lowers operating income and GAAP taxes. However, the IRS treats option expense differently, and only allows their tax deductibility at the time the options are exercised/expire and the true cost is known.

This means that cash taxes in the period the options are expensed are higher than GAAP taxes. The delta goes into a deferred income tax asset on the balance sheet. When the options are exercised/expire, their actual cost becomes known and the precise tax deduction allowed by the IRS can then be determined. There is then a balancing up event. If the original estimate of the options' cost was too low, there will be more tax deduction allowed than was at first estimated. This 'excess' is run through the P&L in the period when it becomes known (i.e. the quarter in which the options are exercised). It raises net income (by lowering taxes) and is subsequently deducted out in the calculation of operating cashflow because it relates to expenses/earnings from a prior period.

Criticism

Alan Greenspan was critical of the structure of present-day options structure, so John Olagues created a new form of employee stock option called "dynamic employee stock options", which restructure the ESOs and SARs to make them far better for the employee, the employer and wealth managers.

Charlie Munger, vice-chairman of Berkshire Hathaway and chairman of Wesco Financial and the Daily Journal Corporation, has criticized conventional stock options for company management as "... capricious, as employees awarded options in a particular year would ultimately receive too much or too little compensation for reasons unrelated to employee performance. Such variations could cause undesirable effects, as employees receive different results for options awarded in different years", [20] and for failing "to properly weigh the disadvantage to shareholders through dilution" of stock value. [20] Munger believes profit-sharing plans are preferable to stock option plans. [20]

According to Warren Buffett, investor Chairman & CEO of Berkshire Hathaway, "[t]here is no question in my mind that mediocre CEOs are getting incredibly overpaid. And the way it's being done is through stock options." [21]

Other criticisms include:

  1. Dilution can be very costly to shareholder over the long run.
  2. Stock options are difficult to value.
  3. Stock options can result in egregious compensation of executive for mediocre business results.
  4. Retained earnings are not counted in the exercise price.
  5. An individual employee is dependent on the collective output of all employees and management for a bonus.[ citation needed ]

Indexed Options Supporters

Other critics of (conventional) stock option plans in the US include supporters of "reduced-windfall" or indexed options for executive/management compensation. These include academics such as Lucian Bebchuk and Jesse Fried, institutional investor organizations the Institutional Shareholder Services and the Council of Institutional Investors, and business commentators. [22] [23]

Reduced-windfall options would adjust option prices to exclude "windfalls" such as falling interest rates, market and sector-wide share price movements, and other factors unrelated to the managers' own efforts. This can be done in a number of ways such as

According to Lucian Bebchuk and Jesse Fried, "Options whose value is more sensitive to managerial performance are less favorable to managers for the same reasons that they are better for shareholders: Reduced-windfall options provide managers with less money or require them to cut managerial slack, or both." [26]

However, as of 2002, only 8.5% of large public firms issuing options to executives conditioned even a portion of the options granted on performance. [27]

A 1999 survey of the economics of executive compensation lamented that

Despite the obvious attractive features of relative performance evaluation, it is surprisingly absent from US executive compensation practices. Why shareholders allow CEOs to ride bull markets to huge increases in their wealth is an open question. [28]

Controversy

Stock option expensing has been surrounded in controversy since the early 1900s. The earliest attempts by accounting regulators to expense stock options were unsuccessful and resulted in the promulgation of FAS123 by the Financial Accounting Standards Board which required disclosure of stock option positions but no income statement expensing, per se. The controversy continued and in 2005, at the insistence of the SEC, the FASB modified the FAS123 rule to provide a rule that the options should be expensed as of the grant date. One misunderstanding is that the expense is at the fair value of the options. This is not true. The expense is indeed based on the fair value of the options but that fair value measure does not follow the fair value rules for other items which are governed by a separate set of rules under ASC Topic 820. In addition the fair value measure must be modified for forfeiture estimates and may be modified for other factors such as liquidity before expensing can occur. Finally the expense of the resulting number is rarely made on the grant date but in some cases must be deferred and in other cases may be deferred over time as set forth in the revised accounting rules for these contracts known as FAS123 (revised). [29]

See also

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Incentive stock options (ISOs), are a type of employee stock option that can be granted only to employees and confer a U.S. tax benefit. ISOs are also sometimes referred to as statutory stock options by the IRS. ISOs have a strike price, which is the price a holder must pay to purchase one share of the stock. ISOs may be issued both by public companies and private companies, with ISOs being common as a form of executive compensation for public companies, and common as a form of equity compensation in private start-up companies.

Lattice model (finance) method for evaluating stock options that divides time into discrete intervals

In finance, a lattice model is a technique applied to the valuation of derivatives, where a discrete time model is required. For equity options, a typical example would be pricing an American option, where a decision as to option exercise is required at "all" times before and including maturity. A continuous model, on the other hand, such as Black–Scholes, would only allow for the valuation of European options, where exercise is on the option's maturity date. For interest rate derivatives lattices are additionally useful in that they address many of the issues encountered with continuous models, such as pull to par. The method is also used for valuing certain exotic options, where because of path dependence in the payoff, Monte Carlo methods for option pricing fail to account for optimal decisions to terminate the derivative by early exercise., though methods now exist for solving this problem.

Stock appreciation rights (SARs) is a method for companies to give their management or employees a bonus if the company performs well financially. Such a method is called a 'plan'. SARs resemble employee stock options in that the holder/employee benefits from an increase in stock price. They differ from options in that the holder/employee does not have to purchase anything to receive the proceeds. They are not required to pay the (options') exercise price, but just receive the amount of the increase in cash or stock.

Options backdating is the practice of altering the date a stock option was granted, to a usually earlier date at which the underlying stock price was lower. This is a way of repricing options to make them valuable or more valuable when the option "strike price" is fixed to the stock price at the date the option was granted. Cases of backdating employee stock options have drawn public and media attention.

Stock option expensing is a method of accounting for the value of share options, distributed as incentives to employees, within the profit and loss reporting of a listed business. On the income statement, balance sheet, and cash flow statement say that the loss from the exercise is accounted for by noting the difference between the market price of the shares and the cash received, the exercise price, for issuing those shares through the option.

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References

  1. see Employee Stock Option FAQ's Archived 2012-05-10 at the Wayback Machine
  2. "Exhibit 4.02 Sample Stock Option Agreement". www.sec.gov. Retrieved 2018-12-05.
  3. see Employee Stock Options Plans, U.S. Securities and Exchange Commission.
  4. "What is a 409A valuation?". Carta. 2018-05-31.
  5. "Exercise Employee Stock Options, Liquidity for Your Stock Options | ESO Fund". Employee Stock Option Fund.
  6. The Complete Guide to Employee Stock Options, Frederick D. Lipman, Prima Venture, 2001, p.120
  7. "Ryan v. Crown Castle NG (NextG) Networks, ___ Cal. Ct. App. ___ (2016)" (PDF). Archived from the original (PDF) on 2017-01-11. Retrieved 2017-01-11.
  8. "Option Pricing Calculators by Peter Hoadley". www.hoadley.net.
  9. "Option Pricing Calculators by Peter Hoadley". www.hoadley.net.
  10. "Tax and Employee Share Schemes".
  11. "Archived copy". Archived from the original on 2012-01-31. Retrieved 2012-01-31.CS1 maint: archived copy as title (link)
  12. Leung and Sircar, 2009
  13. 1 2 Mun, 2004, pg. 126.
  14. See, for example West, 2009.
  15. 1 2 U.S. Securities and Exchange Commission, Staff Accounting Bulletin no. 107, 2005.
  16. Mark Rubinstein (1995). "On the Accounting Valuation of Employee Stock Options", Journal of Derivatives , Fall 1995
  17. Peter Hoadley, Employee Stock Option Valuation: The Hull-White Model.
  18. D. Taylor and W. van Zyl, Hedging employee stock options and the implications for accounting standards Archived 2013-05-30 at the Wayback Machine , Investment Analysts Journal , No. 67 2008
  19. Treasury Regulations § 1.83-7(b)
  20. 1 2 3 "Daily Journal Corporation Proxy Statement" . Retrieved 7 April 2011.
  21. Raising The Bar Stock options have become even the subpar CEO's way to wealth. Fortune magazine | By Shawn Tully| June 8, 1998
  22. Jennifer Reingold, `Commentary: An Option Plan Your CEO Hates,` BusinessWeek February 28, 2000, 82
  23. James P. Miller, "Indexing Concept Aims at Fairness", Chicago Tribune, May 4, 2003
  24. p.141
  25. Bebchuk and Fried, Pay Without Performance (2004), (p.139-40)
  26. Bebchuk and Fried, Pay Without Performance (2004), (p.144)
  27. Lublin, Joann S. "Why the Get-Rich-Quick Day May be Over", Wall Street Journal, April 14, 2003
  28. from a 1999 survey of the economics of executive compensation by John Abowd and David Kaplan, "Executive Compensation: Six Questions That Need Answering,` Journal of Economic Perspectives 13 (1999)) (p.147)
  29. See Summary of Statement No. 123 (revised 2004) and, for the earlier interpretation, Accounting for Certain Transactions involving Stock Compensation—an interpretation of APB Opinion No. 25. FASB.

General reference

Valuation

Issues

Calculation resources