Employee stock option

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.[1] 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".[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.

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.

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[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 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.

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."[17]

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

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).

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",[30] and for failing "to properly weigh the disadvantage to shareholders through dilution" of stock value.[30] Munger believes profit-sharing plans are preferable to stock option plans.[30]

According to

External links

Brian K. Boonstra: Model For Pricing ESOs (Excel spreadsheet and VBA code)
Joseph A. D’Urso: Valuing Employee Stock Options (Excel spreadsheet)
Thomas Ho: Employee Stock Option Model (Excel spreadsheet)

References

see Employee Stock Option FAQ's^
Exhibit 4.02 Sample Stock Option Agreement www.sec.gov, retrieved 2018-12-05^
see Employee Stock Options Plans, U.S. Securities and Exchange Commission.^

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.[25] 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

Differences between GAAP accounting and U.S. tax rules create a timing gap in how stock-based compensation is reflected on the profit-and-loss (P&L) statement. Under GAAP, companies must estimate the fair value of employee stock options on the grant date and recognize that amount as an expense over the vesting period. According to FASB ASC 718, “the grant-date fair value of the award shall be recognized as compensation cost over the requisite service period.”[26] This reduces operating income and lowers the GAAP income tax provision.

For tax purposes, however, the IRS takes a different approach. Stock option deductions are only allowed when the options are exercised or expire and the actual taxable amount is known. The IRS states that “you may deduct the amount by which the fair market value of the stock exceeds the option price when the employee exercises the option.”[27] Because of this timing difference, cash taxes paid in the period when the GAAP expense is recognized are often higher than the GAAP tax expense. The difference is recorded as a deferred tax asset on the balance sheet.

When the options are eventually exercised or expire, the actual tax deduction becomes known. If the deduction is larger than the amount originally estimated, the company records what is known as an “excess tax benefit.” PwC describes this adjustment as “the tax deduction in excess of the cumulative compensation cost recognized for financial reporting purposes.”[28] This reduces income tax expense and increases net income in the period of exercise. The CFA Institute notes that these benefits are “removed from operating cash flow because they arise from compensation costs of prior periods rather than current-period operating activities.”[29]

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.[32][33]

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."[36]

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.[37]

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.[38]"

`indexing` or otherwise adjusting the exercise price of options to the average performance of the firm's particular industry to screen out broad market effects, (e.g. instead of issuing X many options with an exercise price equal to the current market price of $100, grant X many options whose strike price is $100 multiplied by an industry market index)[34] or

making the vesting of at least some options contingent on share price appreciation exceeding a certain benchmark (say, exceeding the appreciation of the shares of the bottom 20% of firm in the company's sector).[35]

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).[39]

Objectives

Features

Overview

Contract differences

Valuation

Accounting and taxation treatment

General accepted accounting principles in the United States (GAAP)

Criticism

See also

External links

References

Taxation

Excess tax benefits from stock-based compensation

Excess tax benefits from stock-based compensation

Indexed options supporters

Controversy