Finance:Employee stock option

Short description: Option for employee to share in company stock

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

Employee stock options are commonly viewed as an internal agreement providing the possibility to participate in the share capital of a company, granted by the company to an employee as part of the employee's remuneration package. Regulators and economists have since specified that ESOs are compensation contracts.

These nonstandard contracts exist between an employee and employer, under which the employer is obligated to deliver a specified number of shares if the employee chooses to exercise their stock options. 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". 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.

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, 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.

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.

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 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, 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:

• Exercise price: The exercise price is non-standardized and is usually the current price of the company stock at the time of issue. Alternatively, a formula may be used, such as sampling the lowest closing price over a 30-day window on either side of the grant date. On the other hand, choosing an exercise at grant date equal to the average price for the next sixty days after the grant would eliminate the chance of back dating and spring loading. Often, an employee may have ESOs exercisable at different times and different exercise prices.
• Quantity: Standardized stock options typically have 100 shares per contract. ESOs usually have some non-standardized amount.
• Vesting: Initially if X number of shares are granted to employee, then all X may not be in his account.
  • Some or all of the options may require that the employee continue to be employed by the company for a specified term of years before "vesting", i.e. selling or transferring the stock or options. Vesting may be granted all at once ("cliff vesting") or over a period time ("graded vesting"), in which case it may be "uniform" (e.g. 20% of the options vest each year for 5 years) or "non-uniform" (e.g. 20%, 30% and 50% of the options vest each year for the next three years).
  • Some or all of the options may require a certain event to occur, such as an initial public offering of the stock, or a change of control of the company.
  • The schedule may change pending the employee or the company having met certain performance goals or profits (e.g., a 10% increase in sales).
  • It is possible for some options to time-vest but not performance-vest. This can create an unclear legal situation about the status of vesting and the value of options at all.
• Liquidity: ESOs for private companies are not traditionally liquid, as they are not publicly traded.
• Duration (Expiration): ESOs often have a maximum maturity that far exceeds the maturity of standardized options. It is not unusual for ESOs to have a maximum maturity of 10 years from date of issue, while standardized options usually have a maximum maturity of about 30 months. If the holder of the ESOs leaves the company, it is not uncommon for this expiration date to be moved up to 90 days.
• Non-transferable: With few exceptions, ESOs are generally not transferable and must either be exercised or allowed to expire worthless on expiration day. There is a substantial risk that when the ESOs are granted (perhaps 50%) that the options will be worthless at expiration. This should encourage the holders to reduce risk by selling exchange traded call options. In fact it is the only efficient way to manage those speculative ESOs and SARs. Wealth Managers generally advise early exercise of ESOs and SARs, then sell and diversify.
• Over the counter: Unlike exchange traded options, ESOs are considered a private contract between the employer and employee. As such, those two parties are responsible for arranging the clearing and settlement of any transactions that result from the contract. In addition, the employee is subjected to the credit risk of the company. If for any reason the company is unable to deliver the stock against the option contract upon exercise, the employee may have limited recourse. For exchange-trade options, the fulfillment of the option contract is guaranteed by the Options Clearing Corp.
• Tax issues: There are a variety of differences in the tax treatment of ESOs having to do with their use as compensation. These vary by country of issue but in general, ESOs are tax-advantaged with respect to standardized options. See below.
  • 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 or NSOs)
  • In the UK, there are various approved tax and employee share schemes, including Enterprise Management Incentives (EMIs). (Employee share schemes that aren’t approved by the UK government don’t have the same tax advantages.)

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. Here, via requisite modifications, the model should incorporate the features described above. In general—due to these—the value of the ESO will typically "be much less than [standard] prices for corresponding market-traded options".

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 IASB 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 the method currently followed. "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 sometimes called "suboptimal early exercise behavior". 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 above reduction in value, relative to standard options.

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, may also be incorporated in a lattice model; although a finite difference model would be more correctly (if less easily) applied in these cases. See contingent claim valuation for further discussion.

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. For modelling purposes, where Black–Scholes is used, this number is (often) based on 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, or back-solved such that Black–Scholes returns a given lattice-based result (see Greeks (finance) § Theta).

A KPMG study (from 2012) suggests that most ESO valuations use either Black–Scholes or a lattice model, as adjusted to incorporate the features of typical ESOs. The more specialized Hull–White model (2004) is also widely employed, while the work of Carpenter (1998) is acknowledged as the first attempt at a "thorough treatment"; see also Rubinstein (1995). These are essentially modifications of the standard binomial model (although may sometimes be implemented as a trinomial tree).