By John Summa, CTA, PhD, Founder of HedgeMyOptions.com and OptionsNerd.com

Employee stock options
, or ESOs, represent one form of equity compensation granted by companies to their employees and executives. They give the holder the right to purchase the company stock at a specified price for a limited duration of time in quantities spelled out in the options agreement.

ESOs represent the most common form of equity compensation. In this tutorial, the employee (or grantee) also known as the "optionee", will learn the basics of ESO valuation, how they differ from their brethren in the listed (exchange traded) options family, and what risks and rewards are associated with holding these during their limited life. Additionally, the risk of holding ESOs when they get in the money versus early or premature exercise will be examined.

In Chapter 2,we describe ESOs at a very basic level. When a company decides that it would like to align its employee interests with the aims of the management, one way to do this is to issue compensation in the form of equity in the company. It is also a way of deferring compensation. Restricted stock grants, incentive stock options and ESOs all are forms equity compensation can take. While restricted stock and incentive stock options are important areas of equity compensation, they will not be explored here. Instead, the focus is on non-qualified ESOs.

We begin by providing a detailed description of the key terms and concepts associated with ESOs from the perspective of employees and their self interest. Vesting, expiration dates and expected time to expiration, volatility pricing, strike (or exercise) prices, and many other useful and necessary concepts are explained. These are important building blocks of understanding ESOs – an important foundation for making informed choices about how to manage your equity compensation.

ESOs are granted to employees as a form of compensation, as mentioned above, but these options do not have any marketable value (since they do not trade in a secondary market) and are generally non-transferable. This is a key difference that will be explored in greater detail in Chapter 3, which covers basic options terminology and concepts, while highlighting other similarities and differences between the traded (listed) and non-traded (ESO) contracts.

An important feature of ESOs is their theoretical value, which is explained in Chapter 4. Theoretical value is derived from options pricing models like the Black-Scholes (BS), or a binomial pricing approach. Generally speaking, the BS model is accepted by most as a valid form of ESO valuation and meets Financial Accounting Standards Board (FASB) standards, assuming that the options do not pay dividends. But even if the company does pay dividends, there is a dividend-paying version of the BS model that can incorporate the dividend stream into the pricing of these ESOs. There is ongoing debate in and out of academia, meanwhile, about how to best value ESOs, a topic that is well beyond this tutorial.

Chapter 5looks at what a grantee should be thinking about once an ESO is granted by an employer. It is important for the employee (grantee) to understand the risks and potential rewards of simply holding ESOs until they expire. There are some stylized scenarios that can be useful in illustrating what is at stake and what to look out for when considering your options. This segment, therefore, outlines key outcomes from holding your ESOs.

A common form of management by employees to reduce risk and lock in gains is the early (or premature) exercise. This is somewhat of a dilemma, and poses some tough choices for ESO holders. Ultimately, this decision will depend on one's personal risk appetite and specific financial needs, both in the short and long term. Chapter 6 looks at the process of early exercise, the financial objectives typical of a grantee taking this road (and related issues), plus the associated risks and tax implications (especially short-term tax liabilities). Too many holders rely on conventional wisdom about ESO risk management which, unfortunately, may be loaded with conflicts of interest, and therefore may not necessarily be the best choice. For example, the common practice of recommending early exercise in order to diversify assets may not produce the optimal outcomes desired. There are trade offs and opportunity costs that must be carefully examined.

Besides removing the alignment between employee and company (which was the purportedly one of the intended purposes of the grant), the early exercise exposes the holder to a large tax bite (at ordinary income tax rates). In exchange, the holder does lock in some appreciation in value on their ESO (intrinsic value). Extrinsic, or time value, is real value. It represents value proportional to probability of gaining more intrinsic value. Alternatives do exist for most holders of ESOs for avoiding premature exercise (i.e. exercising before expiration date). Hedging with listed options is one such alternative, which is briefly explained in Chapter 7 along with some of the pros and cons of such an approach.

Employees face a complex and often confusing tax liability picture when considering their choices about ESOs and their management. The tax implications of early exercise, a tax on intrinsic value as compensation income, not capital gains, can be painful and may not be necessary once you are aware of some of the alternatives. However, hedging raises a new set of questions and resulting confusion about tax burden and risks, which is beyond the scope of this tutorial.

ESOs are held by tens of millions of employees and executives in North America, and many more worldwide are in possession of these often misunderstood assets known as equity compensation. Trying to get a handle on the risks, both tax and equity, is not easy but a little effort at understanding the fundamentals will go a long way toward demystifying ESOs. That way, when you sit down with your financial planner or wealth manager, you can have a more informed discussion - one that will hopefully empower you to make the best choices about your financial future.

Next: Employee Stock Options: Definitions and Key Concepts »



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