Employee stock option

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An employee stock option is a call option on the common stock of a company, issued as a form of non-cash compensation. Restrictions on the option (such as vesting and limited transferability) attempt to align the holder's interest with those of the business' shareholders. If the company's stock rises, holders of options generally experience a direct financial benefit. This gives employees an incentive to behave in ways that will boost the company's stock price.

Employee stock options are mostly offered to management as part of their executive compensation package. They 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. Employee stock options are similar to warrants, which are call options issued by a company with respect to its own stock.

Stock option expensing became a controversy in the early 2000s, and it was eventually determined that by the Financial Accounting Standards Board that the options should be expensed at their fair value as of the grant date.[1]


[edit] Overview

Employee stock options (ESOs) are non-standardized calls that are issued as a private contract between the employer and employee. Over the course of employment, a company generally issues ESOs to an employee which can be exercised at a particular price set on the grant day, generally the company's current stock price. 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 at whatever stock price was used as the exercise price. At that point, the employee may either sell the stock, or hold on to it in the hope of further price appreciation or hedge the stock position with listed calls and puts. The employee may also hedge the employee stock options prior to exercise with exchange traded calls and puts and avoid forfeiture of a major part of the options value back to the company thereby reducing risks and delaying taxes.

[edit] Contract differences

Employee stock options have the following differences from standardized, exchange-traded options:

[edit] Valuation

The value of an ESO follows the valuation techniques used for standardized options. The same models used in valuing standardized options, such as Black-Scholes and the binomial model, are also used for ESOs. Often, the only inputs to the pricing model that cannot be readily determined is the estimate of future volatility of the stock, and the appropriate expected time to expiration to use. However, there are a variety of services that are now offered to help determine appropriate values.

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 at the grant date using an option pricing model. The majority of public and private companies apply the Black-Scholes model, however, through September 2006, over 350 companies have publicly disclosed the use of a binomial model in SEC filings.

[edit] Employee stock options in the United States

[edit] GAAP

FAS 123 Revised, does not state a preference in valuation model. However, it does state 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 in paragraph A8, can provide a fair value estimate that is consistent with the measurement objective and fair-value-based method of this Statement." The simplest and most common form of a lattice model is a binomial model.

According to US generally accepted accounting principles in effect before June 2005, stock options granted to employees did not need to be recognized as an expense on the income statement when granted, although the cost 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). Only a disclosure in the footnotes was required. Intentions from the international accounting body IASB indicate that similar treatment will follow internationally.

Method of option expensing: SAB 107, issued by the SEC, does not specify a preferred valuation model, but 3 criteria must be met when selecting a valuation model: The model 1) is applied in a manner consistent with the fair value measurement objective and other requirements of FAS123R; 2) is based on established financial economic theory and generally applied in the field; and 3) reflects all substantive characteristics of the instrument (i.e. assumptions on volatility, interest rate, dividend yield, etc.) need to be specified...

[edit] Types of employee stock options

In the U.S., stock options granted to employees are of two forms, that differ primarily in their tax treatment. They may be either:

[edit] Taxation of employee stock options in the United States

Because most employee stock options are non-transferable, are not immediately exercisable although they can be readily hedged to reduce risk, 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. 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. Incentive stock options (ISO) are not, 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.

[edit] Financial accounting solutions for employee stock options

[edit] See also

[edit] Literature

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