The benefits of an equity compensation plan to employers are:. In terms of stock options, there are two main types:. There are two key parties in the ESO, the grantee employee and grantor employer. 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 grantee is given equity compensation in the form of ESOs, usually with certain restrictions, one of the most important of which is the vesting period.

What are employee stock options (ESOs)?

The vesting period is the length of time that an employee must wait in order to be able to exercise their ESOs. Why does the employee need to wait? Because it gives the employee 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.

If you have received an options grant, you must carefully go through your company's stock options plan, as well as the options agreement, to determine the rights available and restrictions applied to employees. 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, or 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 predetermined dates, as set out in the vesting schedule.

What is Esop? Definition of Esop, Esop Meaning - The Economic Times

As mentioned earlier, we had assumed that the ESOs have 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. In some ESO agreements, a company may offer a reload option. A reload option is a nice provision to take advantage of. We now arrive at the ESO spread. As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread. The following points need to be borne in mind with regard to ESO taxation:.

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.

The value of an option consists of intrinsic value and time value. 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, 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.

To calculate the time value for your ESOs, you would have to use a theoretical pricing model like the well-known Black-Scholes option pricing model to compute the fair value of your ESOs. 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 value 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 left , 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, time to expiration, and above 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. The biggest and most obvious difference between 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. 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. 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. LEAPs long-term equity anticipation securities are among the longest-dated options available, but even they only go two years out, which would only help if your ESOs have two years or less to expiration. 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. Option prices can vary widely, depending on the assumptions made in the input variables. 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, the time to expiration is specified and cannot be arbitrarily changed.

Assumptions about volatility can also have a significant impact on option prices. If your company assumes lower than normal levels of volatility, your ESOs would be priced lower. 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.

FAQs – Employee Stock Purchase Plans

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. 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.

Note that despite the term "automatic exercise," you still have control over the eventual outcome, by providing alternate instructions to your broker that take precedence over any automatic exercise procedures, or by closing out the position prior to expiration. 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. With ESOs, since the strike price is typically the stock's closing price on a particular day, there are no standardized strike prices.

In the mids, an options backdating scandal in the U. This practice involved granting an option at a previous date instead of 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 grants to the SEC within two business days. 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, 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. 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.

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But as the counterparty to your ESOs is your company, with no intermediary in between, 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. 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.

In addition to your ESOs, if you also have a significant amount of company stock in your employee stock ownership plan ESOP , you may unwittingly have too much exposure to your company, a concentration risk that has been highlighted by FINRA.

Understanding the interplay of these variables—especially volatility and time to expiration—is crucial for making informed decisions about the value of your ESOs. The first table below uses the Black-Scholes option pricing model to isolate the impact of time decay while keeping volatility constant, while the second illustrates the impact of higher volatility on option prices.

You can generate option prices yourself using this nifty options calculator at the CBOE website. 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:.

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This increase in volatility has a significant effect on option prices. Similar results are obtained by changing the variables to levels that prevail at present.

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The key takeaway from this section is that merely because your ESOs have no intrinsic value, do not make the naive assumption that they are worthless. Because of their lengthy time to expiration compared to listed options, ESOs have a significant amount of time value that should not be frittered away through early exercise. As discussed in the preceding section, your ESOs can have significant time value even if they have zero or little intrinsic value.

In this section, we use the common year grant term to expiration to demonstrate the risk and reward associated with owning ESOs. As your exercise price and the stock price are the same, this is an at-the-money option. Once the stock begins to rise, the option has intrinsic value, which is intuitive to understand and easy to compute. But a common mistake is not realizing the significance of time value, even on the grant day, and the opportunity cost of premature or early exercise.

In fact, your ESOs have the highest time value at grant assuming that volatility does not spike soon after you acquire the options.