Employee Stock Options: Definitions and Key Concepts
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  1. Employee Stock Options: Introduction
  2. Employee Stock Options: Definitions and Key Concepts
  3. Employee Stock Options: Comparisons To Listed Options
  4. Employee Stock Options: Valuation and Pricing Issues
  5. Employee Stock Options: Risk and Reward Associated with Owning ESOs
  6. Employee Stock Options: Early Or Premature Exercise
  7. Employee Stock Options: Premature Exercise Risks
  8. Employee Stock Options: Conclusion
Employee Stock Options: Definitions and Key Concepts

Employee Stock Options: Definitions and Key Concepts

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

Let's begin with the participants – the grantee (employee) and grantor (employer). The latter is the company that employs the grantee or employee. A grantee can be an executive, or a wage or salaried worker, and is also often referred to as the optionee. This party is given the ESO equity compensation, usually with certain restrictions. One of the most important restrictions is what is known as the vesting period. The vesting period is the time that an employee must wait in order to be able to exercise ESOs. Exercise of ESOs, where the optionee notifies the company that he or she would like to buy the stock, allows the optionee to buy the referenced shares at the strike price indicated in the ESO options agreement. The acquired stock (in whole or parts) can then be immediately sold at the next best market price. The higher the market price from the exercise or strike price, the larger the "spread" and, therefore, the bigger the compensation (not "gain") the employee earns. As you will see later, this triggers a tax event whereby the ordinary compensation tax rate is applied to the spread.

For example, if your ESOs have an exercise price of $30, when you exercise your ESOs you will be able to acquire (buy) the specified shares of stock at $30. In other words, no matter how much higher the market price for the stock is, at the point of exercise you get to buy the stock at the strike price, and the bigger the spread between strike and market price, the bigger the earnings.

Vesting
The ESOs are considered vested when the employee is allowed to exercise and purchase stock, but the stock may not be vested in some (rare) cases. It is important to read carefully what is known as the company's stock options plan and the options agreement to determine the rights and key restrictions available to employees. The former is put together by the board of directors and contains details of the rights of a grantee or optionee. The options agreement, however, will provide the most important details, such as the vesting schedule, the shares represented by the grant and the exercise or strike price. Of course, the terms associated with the vesting of the ESOs will be spelled out, too. (For more on executive compensation limits, read How Restricted Stocks And RSUs Are Taxed.)

ESOs typically vest in portions across time in the form of a vesting schedule. This is spelled out in the options agreement. ESOs will normally vest at predetermined dates. For example, you may have 25% vest in one year, (one year from the grant date) another 25% may vest in two years, and so on until you are considered "fully vested". If you don't exercise your options after year one (the 25% that vested in that year), you then have a cumulative growth in percent vested, and now exercisable options, across the two years. Once all have vested, meanwhile, you can then exercise the entire group, or you can exercise part of the fully vested ESOs. (For more insight, read How do I "vest" something?)

Paying for the Stock
In other words, at this point you could request to exercise 25% of 1,000 shares granted in the ESO, meaning you would get 250 shares of stock at the strike price of the option. You will need to come up with the cash to pay for the stock, but the price you pay is the strike price, not the market price (withholding tax and other related state and federal income taxes are deducted at this time by the employer and the purchase price will typically include these taxes to the stock price purchase cost).

All details about vesting of ESOs (should you be granted some or have some currently), can again be found in what is called the "options agreement" and "company stock plan". Be sure to read these carefully, as fine print can sometimes hide important clues about what you may or may not be able to do with your ESOs, and exactly when you can begin to manage them effectively. There are some tricky issues here, especially regarding termination of employment (either voluntarily or involuntarily).

If your employment is terminated, unlike vested stock, you will not be able to hold on to your options before or after they are vested. While some consideration may be given to circumstances surrounding why employment was terminated, most often your ESO agreement is terminated with employment, or just after. If options have vested prior to termination of employment, you may have a small window (known as a grace period) to exercise your ESOs. If you are hedging positions, the probability of employment termination occurring is an important consideration. This is because if you lose the equity you are attempting to hedge, you are left holding hedges that are exposed to their own risk (having no equity offset). If you have losses on your hedges and gains on your ESOs that cannot be realized, a large risk of loss is created. (Learn more about how hedging works in Hedging In Layman's Terms.)

The ESO Spread
Let's take a closer look at the so-called "spread" between the strike and the stock price. If you have ESOs with a strike of $25, the stock price is at $50, and you want to exercise 25% of your 1,000 shares allowed per your ESOs, you would need to pay $25 x 250 for the shares, which is equal to $6,250 before taxes. At this time, however, the value in the market is $12,500. Therefore, if you exercise and sell at the same time, the shares you acquired from the company from the exercise of your ESOs would net you a total of $6,250 (pretax). As mentioned above, however, "gain" of intrinsic (spread) value is taxed as ordinary income, all due in the year you do the exercise. And what's worse, you receive no tax offset from the loss of time or extrinsic value on the share of the ESOs exercised, which could be considerable.

Returning to the issue of taxes, if you have a 40% tax rate applied, you not only give up all the time value in an exercise, but you give up 40% of the intrinsic value capture in the exercise. So that $6,250 now shrinks to $3,750. If you do not sell the stock, you are still subject to the tax upon exercise, an often overlooked risk. Any gains on the stock after exercise, however, would be taxed as capital gains, long or short term depending on how long you hold the acquired stock (You would need to hold the acquired stock for one year and a day following exercise to qualify for the lower capital gains tax rate). (For more on capital gains taxes, see Tax Effects On Capital Gains.)

Let's assume your ESO has vested, or a portion of your grant (say 25% of 1,000 shares, or 250 shares) and you would like to exercise and acquire 250 shares of the company stock. You would need to notify your company of the intent to exercise. You would then be required you to pay the price of the exercise. As you can see below, if the stock is trading at $50 and your exercise price is $40, you would need to come up with $10,000 to purchase the stock ($40 x 250 = $10,000). But there is more.

If these are non-qualified stock options, you would also have to pay withholding tax (covered in more detail in the section of this tutorial on tax implications). If you sell your stock at the market price of $50, you see a "gain" of $2,500 above the exercise price ($12,500 - $10,000), which is the "spread" (sometimes referred to as the "bargain element").

The $2,500 represents the amount the options are in the money (how far above the strike price (i.e. $50 - $40 = $10). This in-the-money amount is also your taxable income, an event looked at by the IRS as compensation increase, and thus taxed at ordinary income tax rates.

Option Particulars Price Value

XYZ Stock Price
$50 $12,500
XYZ ESO Strike Price $40 $10,000
ESO Intrinsic Value $10 $2,500
ESO Exercise "Gain" $2,55 ($10 x 250) $2,500
Figure 1: A simple ESO exercise to acquire 250 shares with $10 intrinsic value

Regardless of whether the acquired 250 shares are sold, the "gain" upon exercise is realized and triggers a tax event. Of course, once you acquire the stock, if there are any price changes, assuming you do not liquidate, this will produce either more gains or some losses on the stock position. The latter parts of this tutorial look at tax implications of holding the stock versus selling it immediately upon exercise. Holding part or all of the acquired stock raises some thorny issues regarding tax liability mismatching.

Intrinsic Versus Time Value
As you can see in the table above, the amount of intrinsic value is $10. This value, however, is not the only value on the options. An invisible value known as time value is also present, a value that is forfeited upon exercise. Depending on the amount of time remaining until expiration (the date the ESOs expire) and several other variables, time value can be larger or smaller. Most ESOs have a stated expiration date of up to 10 years. So how do we "see" this time value component of value?

You need to use a theoretical pricing model, like Black-Scholes, which will compute for you the fair value of your ESOs. You should be aware that the exercise of an ESO, while it may capture intrinsic value, usually gives up time value (assuming there is any left), resulting in a potentially large hidden opportunity cost, which may actually be larger than the gain represented by intrinsic value. (For more on how this model works, see Accounting and Valuing Employee Stock Options.)

The value composition of your ESOs will shift with movement of the stock price and time remaining until expiration (and with changes in volatility levels). When the stock price is below the strike price, the option is considered to be out of the money (also popularly known as "under water"). When at or out of the money, the ESO has no intrinsic value, just time value (the spread is zero when at the money). Since ESOs are not traded in a secondary market, you cannot "see" the value they truly have (since there is no market price like with their listed options brethren). Again, you need a pricing model to plug inputs into (strike price, time remaining, stock price, risk-free interest rates and volatility). This will produce a theoretical, or fair-value, price, which will represent pure time value (also known as extrinsic value).

Option Particulars Price Value

XYZ Stock Price
$30 $7,500
XYZ ESO Strike Price $40 $10,000
ESO Intrinsic Value $0 $0
ESO Extrinsic Value $15 $3,750
Figure 1: Out of the money ESOs representing the right to buy 250 shares and with $15 assumed time value

As you can see in Figure 2, making an exercise when the ESOs are out of the money (stock price below strike price) makes no financial sense at all. In our example where there is $15 of time value per share ($15 x $250 = $3,750), you would give up $3,750 in time value. The stock price, however, could be bought at $30 in the open market when the exercise price is $40, so there is no need to exercise the option and give up your time value. You could simply buy the stock for $30 and keep your ESOs and actually have a much larger upside potential with no additional risk.

What to Expect in the Terms of the Grant
With most ESOs, you can expect certain uniform conditions regarding basic terms. For example, the exercise price is usually (but not always) designated as the market price of the stock on the day of the grant. Also, the vesting period is probably going to be spread out across a number of years with a cumulative exercisable amount with each partial vesting date. In other words, if ESOs were granted giving you the right to buy 1,000 shares of stock and they vest at 25% per year following a grant date, three years from the grant date you would be able to buy 75%, or 750 shares of the stock.

You would need one more year to vest the remaining 250 shares. Finally, while typically a cash exercise is the only route allowed by some employers, others now allow cashless exercise. Here, an arrangement might be made with a broker or other financial institution to finance the exercise on a very short-term basis (including withholding tax due on an exercise) and then have the loan paid off with immediate sale of the all or part of the acquired stock.
Employee Stock Options: Comparisons To Listed Options

  1. Employee Stock Options: Introduction
  2. Employee Stock Options: Definitions and Key Concepts
  3. Employee Stock Options: Comparisons To Listed Options
  4. Employee Stock Options: Valuation and Pricing Issues
  5. Employee Stock Options: Risk and Reward Associated with Owning ESOs
  6. Employee Stock Options: Early Or Premature Exercise
  7. Employee Stock Options: Premature Exercise Risks
  8. Employee Stock Options: Conclusion
Employee Stock Options: Definitions and Key Concepts
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