Granting stock options to key employees

The Right Way to Grant Equity to Your Employees | First Round Review

 

granting stock options to key employees

Start-ups may also grant stock options to employees who take the risk to work with the company at an early stage with the hope of large payouts once the company goes public or is purchased. If your company is considering granting stock options to your employees, below are some best practices and considerations to keep in mind prior to rolling out an employee stock option plan. The Basics of Stock Option . The Wealthfront Equity Plan is designed to specifically handle the four most important cases for granting equity to employees. Each year, you create a new option pool that addresses the following needs: 1. New Hires: These grants are used to hire new employees at market levels. 2. Jul 27,  · What is an 'Employee Stock Option - ESO'. An employee stock option (ESO) is a stock option granted to specified employees of a company. ESOs offer the options' holder the right to buy a certain amount of company shares at a predetermined price for a specific period of time. An employee stock option is slightly different from an exchange-traded.


Employee Stock Option Plans: Considerations & Best Practices


Employee stock options ESOs are a type of equity compensation granted by companies to their employees and executives.

Rather than granting shares of stock directly, the company gives derivative options on the stock instead. Terms of employee stock options will be fully spelled out for an employee in an employee stock options agreement. The holder may choose to immediately sell the stock in the open market for a profit or hold onto the stock over time.

Stock options are a benefit often associated with startup companies, which may issue them in order to reward early employees when and if the company goes public. They are awarded by some fast-growing companies as an incentive for employees to work towards growing the value of the company's shares.

Stock options can also serve as an incentive for employees to stay with the company. The options are canceled if the employee leaves the company before they vest, granting stock options to key employees. ESOs do not include any dividend or voting rights. These plans are known for providing financial compensation in the form of stock equity. Other types of equity compensation may include: 1.

In broad terms, the commonality between all these equity compensation plans is that they give employees and stakeholders an equity incentive to build the company and share in its growth and success. Incentive stock options ISOsalso known as statutory or qualified options, are generally only offered to key employees and top management.

They receive preferential tax treatment in many cases, as the IRS treats gains on such options as long-term capital gains. Also known as non-statutory stock options, profits on these are considered as ordinary income and are taxed as such. ESOs can have vesting schedules which limits the ability to exercise, granting stock options to key employees.

ESOs are taxed at exercise and stockholders will be taxed if they sell their shares in the open market. The grantee — also known as the optionee — can be an executive or an employee, while the grantor is the company that employs the grantee. The vesting period is the length of time that an employee must wait in order to be able to exercise his or her ESOs. Why does the employee need to wait?

Because it gives the granting stock options to key employees an incentive to perform well and stay with the company. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant. Note that the stock may not be fully vested when purchased with an option in certain cases, despite exercise of the stock options, as the company may not want to run the risk of employees making a quick gain by exercising their options and immediately selling their shares and subsequently leaving the company.

The options agreement will provide the key details of your option grant such as the vesting schedule, how the ESOs will vest, shares represented by the grant, and the strike price. If you are a key employee or executive, it may be possible to negotiate certain aspects of the options agreement, such as a vesting schedule where the shares vest faster, granting stock options to key employees a lower exercise price.

It may also be worthwhile to discuss the options agreement with your financial planner or wealth manager before you sign on the dotted line.

ESOs typically vest in chunks over time at pre-determined dates, as set out in the vesting schedule. As mentioned earlier, we had assumed that the ESOs granting stock options to key employees a term of 10 years. This means that after 10 years, you would no longer have the right to buy shares. Therefore, the ESOs must be exercised before the year period counting from the date of the option grant is up.

It should be emphasized that the record price for the shares is the exercise price or strike price specified in the options agreement, regardless of the actual market price of the stock. Reload option In some ESO agreements, a company may offer a reload option.

A reload option is a nice provision to take advantage of. As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread. The grantee or optionee is not faced with an immediate tax liability when the options are granted by the company. Taxation begins at the time of exercise. The sale of the acquired stock triggers another taxable event. If the employee sells the acquired shares for less than or up to one year after exercise, the transaction would be treated as a short-term capital gain and would be taxed at ordinary income tax rates.

Granting stock options to key employees the acquired shares are sold more than one year after exercise, it would qualify for the lower capital gains tax rate. This spread is taxed as ordinary income in your hands in the year of exercise, even if you do not sell the shares.

This aspect can give rise to the risk of a huge tax liability, if you continue to hold the stock and it plummets in value. The ability to buy shares at a significant discount to the current market price a bargain price, in other words is viewed by the IRS as part of the total compensation package provided to you by your employer, and is therefore taxed at your income tax rate. Thus, even if you do not sell the shares acquired pursuant to your ESO exercise, you trigger a tax liability at the time of exercise.

Intrinsic Value vs. Time value depends on the amount of time remaining until expiration the date when the ESOs expire and several other variables. Given that most ESOs have a stated expiration date of up to 10 years from the date of option grant, granting stock options to key employees, their time value can be quite significant.

While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them. You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair granting stock options to key employees of the ESO.

From there, it is a simple exercise to calculate time value, as can be seen below. The exercise of an ESO will capture intrinsic value but usually gives up time value assuming there is any leftgranting stock options to key employees, resulting in a potentially large hidden opportunity cost. The value of your ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, granting stock options to key employees, time to expiration, and granting stock options to key employees all, volatility.

Consider a situation where your ESOs are out of the money, i. It would be illogical to exercise your ESOs in this scenario for two reasons. Comparisons to Listed Options The biggest and most obvious difference between employee stock options ESOs and listed options is that ESOs are not traded on an exchange, and hence do not have the many benefits of exchange-traded options.

The value of your ESO is not easy to ascertain Exchange-traded options, especially on the biggest stock, have a great deal of liquidity and trade frequently, so it is easy to estimate the value of an option portfolio, granting stock options to key employees. Not so with your ESOs, whose value is not as easy to ascertain, because there is no market price reference point.

Many ESOs are granted with a term of 10 years, but there are virtually no options that trade for that length of time. Option pricing models are therefore crucial for you to know the value of your ESOs. Your employer is required — on the options grant date — to specify a theoretical price of your ESOs in your options agreement.

Be sure to request this information from your company, and also find out how the value of your ESOs has been determined. For example, your employer may make certain assumptions about expected length of employment and estimated holding period before exercise, which could shorten the time to expiration. With listed options, on the other hand, granting stock options to key employees, the time to expiration is specified and cannot be arbitrarily changed.

Assumptions about volatility can also have a significant impact on option prices, granting stock options to key employees.

If your company assumes lower than normal levels of volatility, your ESOs would be priced lower. Specifications are not standardized Listed options have standardized contract terms with regard to number of shares underlying an option contract, expiration date, etc. This uniformity makes it easy to trade options on any optionable stock, whether it is Apple or Google or Qualcomm.

If you trade a call option contract, for instance, you have the right to buy shares of the underlying stock at the specified strike price until expiration. Similarly, a put option contract gives you the right to sell shares of the underlying stock until expiration.

While ESOs do have similar rights to listed options, the right to buy stock is not standardized and is spelled out in the options agreement. No automatic exercise For all listed options in the U. If the third Friday happens to fall on an exchange holiday, the expiration date moves up by a day to that Thursday. Thus, if you owned one call option contract and at expiration, the market price of the underlying stock was higher than the strike price by one cent or more, you would own shares through the automatic exercise feature.

Likewise, if you owned a put option and at expiration, the market price of the underlying stock was lower than the strike price by one cent or more, you would be short shares through the automatic exercise feature.

With ESOs, the exact details about when they expire may differ from one company to the next. Also, as there is no automatic exercise feature with ESOs, you have to notify your employer if you wish to exercise your options. In the mids, an options backdating scandal in the U.

This practice involved granting an option at a previous date than the current date, thus setting the strike price at a lower price than the market price on the grant date and giving an instant gain to the option holder.

Options backdating has become much more difficult since the introduction of Sarbanes-Oxley as companies are now required to report option granting stock options to key employees to the SEC within two business days. Vesting and acquired stock restrictions Vesting gives rise to control issues that are not present in listed options.

ESOs may require the employee to attain a level of seniority or meet certain performance targets before they vest. If the vesting criteria are not crystal clear, it may create a murky legal situation, especially if relations sour between the employee and employer. As well, granting stock options to key employees, with listed options, once you exercise your calls and obtain the stock you can dispose of it as soon as you wish without any restrictions.

However, with acquired stock through an exercise of ESOs, there may be restrictions that prevent you from selling the stock. Even if your ESOs have vested and you can exercise them, the acquired stock may not be vested. This can pose a dilemma, since you may have already paid tax on the ESO Spread as discussed earlier and now hold a stock that you cannot sell or that is declining. Counterparty risk As scores of employees discovered in the aftermath of the s dot-com bust when numerous technology companies went bankrupt, counterparty risk is a valid issue that is hardly ever considered by those who receive ESOs.

With listed options in the U. S, the Options Clearing Corporation serves as the clearinghouse for options contracts and guarantees their performance. Thus, there is zero risk that the counterparty to your options trade will be unable to fulfill the obligations imposed granting stock options to key employees the options contract.

But as the counterparty to your ESOs is your company, with no intermediary in between, granting stock options to key employees, it would be prudent to monitor its financial situation to ensure that you are not left holding valueless unexercised options, or even worse, worthless acquired stock. Concentration risk You can assemble a diversified options portfolio using listed options but with ESOs, you have concentration risk, since all your options have the same underlying stock.

Understanding the interplay of these variables — especially volatility and time to expiration — is crucial for making informed decisions about the value of your employee stock options ESOs.

As can be seen, the greater the time to expiration, the more the option is worth. Since we assume this is an at-the-money option, its entire value consists of time value. The first table demonstrates two fundamental options pricing principles: 1.

Time value is a very important component of options pricing. Option time decay is not linear in nature. The value of options declines as the expiration date approaches, a phenomenon known as time decay, but this time decay is not linear in nature and accelerates close to option expiry. An option that is far out-of-the-money will decay faster than an option that is at the money, because the probability of the former being profitable is much lower than that of the latter.

 

Employee Stock Option (ESO) Definition

 

granting stock options to key employees

 

The granting of stock options is a form of compensation given to key personnel (employees, advisers, other team members etc.) for providing their services. Like any other form of compensation, such as the cash payment of wages and salaries or fees to advisers, it is a cost to the business. The following shows how stock options are granted and exercised: ABC, Inc., hires employee John Smith. As part of his employment package, ABC grants John options to acquire 40, shares of ABC’s common stock at 25 cents per share (the fair market value of a share of ABC common stock at the time of grant). Start-ups may also grant stock options to employees who take the risk to work with the company at an early stage with the hope of large payouts once the company goes public or is purchased. If your company is considering granting stock options to your employees, below are some best practices and considerations to keep in mind prior to rolling out an employee stock option plan. The Basics of Stock Option .