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Home > Business Strategy Best Practice > Employee Stock Options

Business Strategy Best Practice

Employee Stock Options

by Peter Casson

Executive Summary

  • Employee stock options are call options on the employer company’s common stock, and are usually not transferable.

  • Most employee stock options have a vesting period, during which the holder is not unconditionally entitled to the option, with options vesting at the end of the period if performance conditions are met.

  • Employee stock options may be used by companies to recruit, retain, and provide incentives to employees and executives. Companies with weak cash flows that cannot afford to pay employees the market rate entirely in cash may use stock options in lieu of cash.

  • Companies may use employee stock options to capture tax or accounting benefits associated with them.

Introduction

Employee stock options are a component of the compensation package of many employees and executives. As well as providing a mechanism for linking pay with the performance of the company’s stock price, stock options can facilitate the recruitment and retention of employees. The effectiveness of stock option compensation derives from the basic characteristics of options and from particular features found in many employee stock options. This article describes the essential features of employee stock options and explores the ways in which they are used by companies.

Characteristics of Employee Stock Options

Employee stock options are call options granted by an employer on the company’s common stock. Call options are contracts that give holders the right, but not the obligation, to acquire stock at a specified price (the exercise price), either on a specified date or over a specified period. The fair value of a call option has two components. The first, known as intrinsic value, is the amount that the holder would receive were the option to be exercised today. This amount, which cannot be negative, is the greater of zero and the difference between the fair value of the underlying stock and the exercise price of the option. The second, known as time value, is the difference between the fair value and the intrinsic value of the option.

The fair value of a call option on a company’s common stock is sensitive to changes in:

  • The fair value of the underlying stock—the value of the option rises with increases in the fair value of the stock.

  • The expected volatility of the returns on the underlying stock—the value of the option increases with increases in expected volatility.

  • The risk-free rate of interest—the value of the option increases with increases in the risk-free rate.

  • The time until the option expires—the value of the option decreases as time to expiry decreases.

  • The dividends expected to be paid on the underlying stock over the life of the option—the value of the option decreases with increases in the expected dividend payments.

Stock options granted to employees usually have an exercise price equal to the fair value of the underlying stock on the date the option is granted, and have a life of seven to ten years. Stock options generally have additional features that affect their fair value. First, there is usually an initial period, often three years, after the grant of the option (the vesting period), during which the employee is not unconditionally entitled to the option. Rather, the employee’s entitlement to the option at the end of the vesting period only comes about if performance conditions are met. The performance condition for employees is usually to remain in the employment of the grantor company during the vesting period. Options, especially those granted to senior executives, may have additional performance conditions relating to company and/or personal performance. Second, once vested, options are usually forfeited if the employee leaves the grantor company. However, it is usual for employees to be able to exercise options within a period, often 90 days, after leaving the company. The forfeiture provision normally means that employees are forced into an early exercise of in-the-money options. Third, employee stock options are usually nontransferable, which means the employees can only realize value by exercising the option and selling the stock. In so doing, they forego the time value of the option.

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Further reading

Book:

  • Wheeler, Peter R. Stock Options + Grants: The Executive’s Guide to Equity Compensation. Sunnyvale, CA: AdviserPress, 2004.

Article:

  • Hall, B. R. “Six challenges in designing equity-based pay.” Journal of Applied Corporate Finance 15:3 (2003): 49–70.

Website:

  • National Center for Employee Ownership (NCEO): www.nceo.org

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