Employee Stock Options

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 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 are also offered to lower staff, especially by businesses that are not yet profitable. They can also be offered to non-employees: suppliers, consultants, lawyers and promoters, and to members of the company's board of directors for services rendered.

Employee stock options (ESOs) are non-standardized, over the counter options that are issued as a private contract between the employer and employee. Over the course of employment, a company issues vested or non-vested ESOs to an employee which are struck at a particular price - often 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 strike price. At that point, the employee may either sell the stock, or hold on to it in the hope of further price appreciation.

Contract Differences

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

1. Strike. The strike price is non-standardized and is often the current price of the company stock at the time of issue. Alternatively, a formula may be used, such as sampling the lowest closing price over a 30-day window on either side of the grant date. Often, an employee may have ESOs struck at different times and different strike prices.
2. Quantity. Standardized stock options typically have 100 shares per contract. ESOs usually have some non-standardized amount.
   Vesting. Often the number of shares available to be exercised at the strike price will increase as time passes according to some vesting schedule. Vesting only occurs during the duration of the employment.
3. Duration. ESOs often have a maturity that far exceeds the maturity of standardized options. It is not unusual for ESOs to have a maturity of 10 years from date of issue, while standardized options usually have a maximum maturity of about 30 months.
   Non-transferable. With few exceptions, ESOs are generally not transferable and must either be exercised or allowed to expire worthless on termination of employment.
4. Over the counter. Unlike exchange traded options, ESOs are considered a private contract between the employer and employee. As such, those two parties are responsible for arranging the clearing and settlement of any transactions the result from the contract. In addition, the employee is subjected to the credit risk of the company. If for any reason the company is unable to deliver the stock against the option contract upon exercise, the employee may have limited recourse. For exchange-trade options, the fulfillment of the option contract is guaranteed by the credit of the exchange.
5. Tax issues. There are a variety of differences in the tax treatment of ESOs having to do with their use as compensation. These vary by country of issue but in general, ESOs are tax-disadvantaged with respect to standardized options.

Valuation

The value of an ESOs closely follows the valuation techniques used for standardized options. The same models used in valuing standardized options, such as Black-Scholes and binomal model can be used for ESOs. Often, the only inputs to the pricing model that cannot be readily determined is the estimate of future realized volatility on the underlier, and the appropriate interest rate 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.

Accounting

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 U.S. 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 (generally accepted accounting principles) in the US. Each company must begin expensing stock options no later than the first reporting period of a fiscal year beginning after June 15th, 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).

Taxation

Because most employee stock options are non-transferrable, are not immediately exercisable, and have other restrictions, 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 must be held for at least one year after the date of exercise. If any of the additional requirements are not fulfilled, there is a "disqualifying disposition" and the gain realized upon exercise is taxed as ordinary income. When ISO shares are held at exercise and not sold in that calendar year, the spread at exercise is part of the Alternative Minimum Tax calculation.

Types of 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:

1. Incentive stock options (ISOs); and
2. Non-qualified stock options (NQSOs or NSOs)

Incentive Stock Options

Incentive stock options (ISO's), are a type of employee stock option that can be granted only to employees and confer a U.S. tax benefit. ISO's are also sometimes referred to as incentive share options.

The tax benefit is that on exercise the individual does not have to pay ordinary income tax (nor employment taxes) on the difference between the exercise price and the fair market value of the shares issued (however, the holder may have to pay U.S. alternative minimum tax instead). Instead, if the shares are held for 1 year from the date of exercise and 2 years from the date of grant, then the profit (if any) made on sale of the shares is taxed as long-term capital gain. Long-term capital gain is taxed in the U.S. at lower rates than ordinary income.

Although ISOs have more favorable tax treatment than non-ISOs (aka non-statutory stock option (NSO) or non-qualified stock option (NQSO)), they also require the holder to take on more risk by having to hold onto the stock for a longer period of time in order to receive the better tax treatment.

Note further that an employer generally does not claim a corporate income tax deduction (which would be in an amount equal to the amount of income recognized by the employee) upon the exercise of its employee's ISO, unless the employee does not meet the holding-period requirements. But see Coughlan, Section 174 R&E Deduction Upon Statutory Stock Option Exercise, 58 Tax Law. 435 (2005). With NQSOs, on the other hand, the employer is always eligible to claim a deduction upon its employee's exercise of the NQSO.

Additionally, there are several other restrictions which have to be met (by the employer or employee) in order to qualify the compensatory stock option as an ISO. For a stock option to qualify as ISO and thus receive special tax treatment under Section 421(a) of the Internal Revenue Code (the "Code"), it must meet the requirements of Section 422 of the Code when granted and at all times beginning from the grant until its exercise. The requirements include:

1. The option may be granted only to an employee (grants to non-employee directors or independent contractors are not permitted), who must exercise the option while he/she is an employee or no later than three (3) months after termination of employment (unless the option holder is disabled, in which case this three-month period is extended to one year. In case of death the option can be exercised by the legal heirs of the deceased until the expiration date).
2. The option must be granted under a written plan document specifying the total number of shares that may be issued and the employees who are eligible to receive the options. The plan must be approved by the stockholders within 12 months before or after plan adoption.
3. Each option must be granted under an ISO agreement, which must be written and must list the restrictions placed on exercising the ISO. Each option must set forth an offer to sell the stock at the option price and the period of time during which the option will remain open.
4. The option must be granted within 10 years of the earlier of adoption or shareholder approval, and the option must be exercisable only within 10 years of grant.
5. The option exercise price must equal or exceed the fair market value of the underlying stock at the time of grant.
6. The employee must not, at the time of grant, own stock representing more than 10% of voting power of all stock outstanding, unless the option exercise price is at least 110% of the fair market value and the option is not exercisable more than five (5) years from the time of the grant.
7. The ISO agreement must specifically state that ISO cannot be transferred by the option holder other than by will or by the laws of descent and that the option cannot be exercised by anyone other than the option holder.
   The aggregate fair market value (determined as of the grant date) of stock bought by exercising ISOs that are exercisable for the first time cannot exceed $ 100,000 in a calendar year. To the extent it does, Code section 422(d) provides that such options are treated as non-qualified stock options.

Non-Qualified Stock Options

Non-qualified stock options are stock options which do not qualify for the special treatment accorded to incentive stock options.

Incentive stock options are only available for employees and other restrictions apply for them. For regular tax purposes, incentive stock options have the advantage that no income is reported when the option is exercised and, if certain requirements are met, the entire gain when the stock is sold is taxed as long-term capital gains.

In contrast, non-qualified stock options result in additional taxable income to the recipient at the time that they are exercised, the amount being the difference between the exercise price and the market value on that date.

Non-qualified stock options are frequently preferred by employers because the issuer is allowed to take a tax deduction equal to the amount the recipient is required to include in his or her income.

If they have deferred vesting, then taxpayers must comply with special rules for all types of deferred compensation Congress enacted in 2004 in the wake of the Enron scandal known as Section 409A of the IRS Code.