Finance:Employee stock option

Short description: Complex call option on the common stock of a company, granted by the company to an employee

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 differ from standardized, exchange-traded options in a number of practical and structural ways. Because they are used as part of compensation plans rather than traded on public markets, the terms of ESOs tend to reflect the needs of the company issuing them.

• Exercise price: Unlike exchange-traded options, the exercise price of an ESO is not standardized. It is most often set at the fair market value of the company’s stock on the grant date, which is required under U.S. tax rules for both incentive stock options and non-qualified stock options. Some companies use averaging formulas or multi-day price windows to set the exercise price, partly to avoid concerns about backdating or spring-loading.

• Quantity: Exchange-traded option contracts typically cover 100 shares, but ESOs are issued in whatever amount the employer chooses. The number is determined by the company’s compensation program rather than by market convention.

• Vesting: ESOs usually vest over time or after certain conditions are met. Many plans require the employee to remain with the company for a set period, while others include performance targets or event-based triggers such as an IPO or change of control. Vesting can occur all at once (“cliff vesting”) or gradually (“graded vesting”).

• Liquidity: Because ESOs issued by private companies are tied to shares that are not publicly traded, they are generally illiquid. Employees usually cannot sell or hedge these options directly.

• Duration: ESOs typically last far longer than exchange-traded options. A 10-year term from the grant date is common. If an employee leaves the company, however, the remaining exercise window is often shortened to 90 days.

• Non-transferability: ESOs generally cannot be transferred, sold, or assigned. They must be exercised or allowed to expire, which means employees bear the full risk that the options could end up worthless if the stock price stays below the exercise price.

• Over-the-counter nature: ESOs are private contracts between the employer and the employee. Because they are not cleared through an exchange, the employee is exposed to the company’s credit risk if the employer is unable to deliver shares when the option is exercised.

• Tax treatment: Taxation varies by country. In the United States, ESOs are typically issued as either incentive stock options (ISOs) or non-qualified stock options (NQSOs), each with different tax implications. In the United Kingdom, approved plans such as Enterprise Management Incentives (EMIs) may offer favorable tax treatment compared with unapproved plans.

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.

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).

The Hull–White model (2004) is widely used, 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). See below for further discussion, as well as calculation resources, and contingent claim valuation more generally.