Employee Stock Options

Definition

A type of call option used as incentive compensation where an employee is granted a right to purchase the shares of company stock at a predetermined price for a specified period of time, subject to a vesting period.

What It Means

Commonly granted to company executives and key employees, employee stock options or ESOs provide an incentive for hard work giving staff members a way to share in the company’s success. Just like with any other call option, the holder has the right, but not an obligation, to purchase the shares of company stock.

Employee stock options have a number of features that set them apart from ordinary stock options. Qualified stock options receive a very attractive tax treatment as long as they adhere to certain legal requirements:

  • The employee stock option grant must be approved by the company’s shareholders.
  • The options must not be transferable.
  • The option exercise or strike price must be at least equal to the share market price at the time of option grant.
  • The grantee must not own more than 10% voting power in the firm.

If the option grant satisifies these conditions, no taxes are due either upon the executive option grant or option exercise date. Such qualified stock options are covered by the incentive stock option plan under the Economic Recovery Tax Act of 1981. If the employee exercises the stock options at least two years after the grant date, the profits are taxed at a lower capital gains tax rate.

To provide further incentive to the employees, the company may reprice stock options to make them more attractive should the stock price fall below the option strike price.

Deferred compensation under IRC Section 409A

Note that ESOs priced below the fair market value of company stock may be deemed deferred compensation under the US Internal Revenue Code Section 409A. This has important tax consequences for both the employee and the company. Failure to price the ESOs correctly may also result in significant penalties and interest charges.

Employee stock option valuation

In many cases, the employee stock options may represent a significant part of the personal net worth. Hence, it is important to determine the value of such options.

In addition, major financial accounting and reporting standards require that the executive stock options be correctly reported on the company’s financial statements.

Compliance with major financial standards

The American Financial Accounting Standards Board (FASB) Statement No 123 (R) endorses the Binomial Model as an established way to value the employee stock options. This methodology is also recommended under the International Financial Reporting Standards (IFRS).

Stock volatility: key factor in stock option valuation

The volatility of company stock is a key input into the option valuation. For a privately owned company that does not offer its stock to the public, establishing the share price requires that you perform business valuation of the entire firm first. This is repeated for a number of dates over a year or two. The stock volatility can then be calculated as the variance of historic stock returns.

For a public company, you can use the market prices of stock directly to calculate the stock price volatility.

Once you know this key measure of stock price behavior, you can use the Binomial Model to calculate the value of the stock options. Factors affecting the employee stock option value include:

  • Current stock price.
  • Option strike price.
  • Vesting period.
  • Stock volatility.
  • Option expiration time.
  • Cost of debt capital to the company.
  • Dividend payout rate.
  • Percentage of employees expected to leave the company in the future.

Each of these parameters has an impact on the value of employee stock options. You can use the Binomial Model to run sensitivity analysis in order to see how much each parameter affects the value of stock options.

See Also