What Are Employee Stock Options? 2017 update

: Summary


Employee Stock Options - Definition


Employee Stock Options are stock options granted to employees by their companies as a form of compensation or incentive.



Employee Stock Options - Introduction


Granting employee stock options to high level executives as a form of incentive is becoming increasely popular amongst both public and private companies all over the world. In fact, many high level managers expect to be given employee stock options as part of their compensation before they even consider taking up the job! This is especially true in large public listed companies. This has come to be known as the Employee Stock Options Scheme (ESOS). In fact, Employee Stock Options now form the major pool of wealth for about 15% of the executives in America. However, even in 2017, disputes arising from Employee Stock Options will not be regulated or mediated by the SEC. (Read the official statement by the SEC)

Employee Stock Options are call options which grants its holder the right, but not the obligation, to buy the company's shares at a fixed price known as the "Grant" or "strike price" before the expiration date is reached.


How Does Employee Stock Options Work?


If you are given employee stock options, you have the right to buy shares of the company you are working for at a price fixed right now. If the company does well and its share price rises, you have the right to buy those same shares at the lower price stated in the employee stock options and make a profit! Knowing that you make a profit on those employee stock options only if the shares of the company go up, you are therefore motivated to help the company make more money and grow! This is why employee stock options are such a popular mean of compensation right now as it ends up in a win-win situation between the company and its employees.




Employee Stock Options - Simplified Example


Let's assume that you are granted employee stock options to buy 100 shares of your company stocks at $40 while it is trading at $40 now. You are only allowed to exercise the rights vested in those employee stock options 1 year later (vesting period of 1 year). 1 year later, your company did well, have great earnings and its shares soared upwards to $50. You could now exercise your right to buy 100 shares at $40 through the employee stock options, making the difference of $10 as profit. You could then decide to sell those shares for an immediate $10 per share profit or you could continue to hold on to those shares for potential future capital gain.



Employee Stock Options - Terminology


Grant (also known as strike price, option price or exercise price)
The price at which you can buy shares of the company no matter how far it has moved in the future.

Holder


Owners of employee stock options. You are the holder of your employee stock options.

Expiration date (also known as Maturity)


The date by which you must exercise the right to buy shares of the company or let the employee stock options laspe worthless.

Vesting Period


The period of time within which you cannot exercise the right to buy shares of the company. Vesting periods can be as long as several years before the employee stock options becomes fully vested.

Vested Options


Employee Stock Options that are fully vested and ready for exercising after fulfilling the vesting period.

Waiting Period


The period of time within which you cannot sell the shares bought through exercising the employee stock options. It can range from several days to several months.

In The Money


When the shares of the company is higher than the grant. Read more about In The Money Options.

Out Of The Money


When the shares of the company is lower than the grant, making the employee stock options worthless upon expiration. Read more about Out Of The Money Options.



Types Of Employee Stock Options
There are 2 main types of employee stock options and they are known as Incentive stock options (ISOs) and Nonqualified stock options (NSOs).

Incentive Stock Options (ISOs)


Incentive Stock Options or ISOs are employee stock options that allows the employee to defer paying a tax on the unrealized profits until the shares bought with the employee stock options are sold. The company issuing Incentive Stock Options (ISOs) do not receive a tax deduction.

Nonqualified Stock Options (NSOs)


Nonqualified Stock Options or NSOs are employee stock options that requires the employee to pay a tax on the unrealized profits in the shares bought with the employee stock options. The company issuing Nonqualified Stock Options (NSOs) recieves a tax deduction on those unrealized profits.

Clearly, employees would always prefer to recieve Incentive Stock Options.


Please note that this is the practise in the United States. Different countries could have different regulations.




What Can You Do With Your Employee Stock Options


  • Exercise the employee stock options to buy shares and then hold on to the shares for long term.


  • Exercise the employee stock options, buy the shares and then sell all of them after the waiting period.


  • Exercise the employee stock options, buy the shares and then sell a portion of them for some profits while holding the rest for the long term.




  • What You Cannot Do With Your Employee Stock Options


  • Sell your employee stock options to a third party.


  • Exercise your employee stock options if you leave employment during the vesting period.



  • Lately, there are companies offering what they call "transferable employee stock options" where employees can sell their employee stock options to one another in an internal market.




    Vesting Periods Of Employee Stock Options


    Nothing concerns holders of employee stock options more than the vesting period. The vesting period can be as long as several years, meaning that the employee stock options cannot be exercised until many years later! The vesting period serves as a mean of keeping talent within a company. In order to benefit from their employee stock options, holders need to work for their companies until the vesting period is fulfilled. The power of the vesting period in keeping talents increases as the employee stock options goes deeper and deeper in the money when the shares of the company rises over time. All employee stock options becomes worthless if its holder leaves the company (voluntarily or involuntarily) during the vesting period no matter how deep in the money those employee stock options have become! This translates to a dramatic decline in one's net worth and wealth pool! If the holder leaves employment (voluntarily or not) after the vesting period is fulfilled, employee stock options that are out of the money immediately expires and in the money employee stock options must be immediately exercised or forfeited as well.

    Sometimes there more than one vesting period in employee stock options. This is known as a Vesting Schedule where percentage of the employee stock options gets vested every several years. If you own employee stock options for 1000 shares with a vesting schedule spread out over 5 years, you would be able to buy 200 shares every year for the next 5 years.


    Valuing Employee Stock Options


    This is an issue that is as unresolved and tricky as the pricing of publicly traded stock options. The challenge is even greater for employee stock options issued by private companies that does not have publicly traded stocks. For holders of employee stock options granted by publicly listed companies, the market price of the company's stocks is readily available, giving instant information on how much in the money or out of the money their employee stock options are becoming. However, holders of employee stock options granted by private companies are very much at the mercy of their board of directors as they literally vote on and agree on what the market price of their shares should be!



    Benefits Of Employee Stock Options


  • You would usually get more in employee stock options than you would get in cash as incentives or compensation.


  • You would usually make much more money owning employee stock options working in growth companies than getting cash compensation.




  • Disadvantages Of Employee Stock Options


  • Benefits are not immediately visible as vesting periods can be very long.


  • If share price of the company drops below the grant, your employee stock options can become worthless.


  • You need to pay cash to buy shares of the company when exercising your employee stock options.


  • Employee stock options cannot be sold like you can in exchange traded options.


  • Employee stock options granted by private companies can be difficult to put a value to.


  • You lose your employee stock options if you decide to leave employment during the vesting period.




  • Differences Between Employee Stock Options & Exchange Traded Options


    The table below summarizes the main differences between Employee Stock Options generally and exchange traded options.

    Employee Stock Options Exchange Traded Options
    Customised Standardized
    No Ready Market Publicly Traded
    Only Call Options Call & Put Options available
    Vesting Period Can Be Exercised At Anytime
    No Standard Pricing Standardized Pricing Model

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