Employee Stock Options

ByAbhijeet TalapatraPriyanka Menon

Manali Lande

Flow of the Presentation

• What is ESO?• Need for ESO• Features of ESOs• Types of ESOs• Tax Benefits• Valuation of ESO• Pros and Cons

What is ESO?

Definition:“A stock option granted to specified employees of a

company”. ESOs carry the right, but not the obligation, to buy a certain amount of shares in the company at a predetermined price.

OR“An employee stock option is a Warrant on a company's

own stock issued as a form of non-cash compensation”.

What is ESO? Contd..

• An ESO is a call option on the common stock of a company, issued as a form of non-cash compensation.

• Restrictions on the option 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.

• ESOs are mostly offered to management as part of their executive compensation package.

Need For ESO

Owners of a corporation (i.e., the stockholders) have a basic problem. How do they get their employees to make decisions that help the stock price increase?

• ESOs are a powerful motivator, because payoffs to options can be large.

• High stock prices: ESO holders gain and shareholders gain.

• ESOs have no upfront costs to the company.

Need For ESO Contd…

• ESOs can be viewed as a substitute for ordinary wages.

• Therefore, ESOs are helpful in recruiting employees.

• Personal tax incentive– No income taxed until exercised– When taxed, categorized as capital gain (only

50% taxable)

Features of ESOs

• There is a vesting period during which options cannot be exercised

• When employees leave during the vesting period options are forfeited

• When employees leave after the vesting period in-the-money options are exercised immediately and out of the money options are forfeited

• Employees are not permitted to sell options

Features Contd..

• When options are exercised the company issues new shares

• To realize cash from an employee stock option the employee must exercise the options and sell the underlying shares

Types of ESOs• Three options allow employees to tie their investment

earnings to shareholder profit:1. Non-qualified Options :

Do not qualify for favorable tax treatment ,gives employees the chance to contribute their own funds to the company.

2. Employee stock-purchase plans (EPPs) Qualify for favorable tax treatment .Enable employees to turn their work earnings into company investments via a structured offer-and-purchase schedule

3. Incentive Stock Options (ISOs) pay certain employees, such as executives, for good performance

Tax Benefits• ESO Plans may be treated as capital gains instead of

compensation income • The gain made upon sale or transfer--the difference

between the agreed strike price and the stock price—is considered a capital gain.

• Benefits of a better tax rate when you hold onto an investment;

• Options bought at least one year from the grant date and transfer at least two years from this date qualify for the favorable tax treatment.

• Options bought or sold earlier are treated as income. • Non-qualified options gains as income regardless of when

you buy and sell.

Valuation of ESO

Pros and Cons• Advantages : Increases employee loyalty and commitment to the

organization. Employees become owners with a financial stake in the

company's performance. Talented employees will be attracted to the company, and

will be inclined to stay in order to reap the future rewards. Stock options also offer tax advantages to businesses. Companies are not required to record options pending as an

expense. "Granting options enables managers to pay employees with

an IOU rather than cash—with the prospect that the stock market, not the company, will one day pay up”.

• Disadvantages: The difficulty of accounting, expensing options in particular; The opportunity cost of options for the granting firm

higher than the value of options to undiversified executives;

Giving executives extra incentives to manipulate accounting information;

Rewarding executives excessively in the boom market; Failure to penalize bad performance by resetting option

price in the down market Encouraging executives to take excessive risks at the cost

of the shareholders.