What Is an Employee Stock Option (ESO)?
The term employee stock option (ESO) refers to a type of equity compensation granted by companies to their employees and executives. Rather than granting shares of stock directly, the company gives derivative options on the stock instead. These options come in the form of regular call options and give the employee the right to buy the company's stock at a specified price for a finite period of time. Terms of ESOs will be fully spelled out for an employee in an employee stock options agreement.
In general, the greatest benefits of a stock option are realized if a company's stock rises above the exercise price. Typically, ESOs are issued by the company and cannot be sold, unlike standard listed or exchange-traded options. When a stock’s price rises above the call option exercise price, call options are exercised and the holder obtains the company’s stock at a discount. The holder may choose to immediately sell the stock in the open market for a profit or hold onto the stock over time.
- Employee stock options are offered by companies to their employees as equity compensation plans.
- These grants come in the form of regular call options and give an employee the right to buy the company’s stock at a specified price for a finite period of time.
- ESOs can have vesting schedules that limit the ability to exercise.
- ESOs are taxed at exercise and stockholders will be taxed if they sell their shares in the open market.
- They can have significant time value even if they have zero or little intrinsic value.
Understanding Employee Stock Options (ESOs)
Corporate benefits for some or all employees may include equity compensation plans. These plans are known for providing financial compensation in the form of stock equity. ESOs are just one type of equity compensation a company may offer. Other types of equity compensation may include:
- Restricted Stock Grants: these give employees the right to acquire or receive shares once certain criteria are attained, like working for a defined number of years or meeting performance targets.
- Stock Appreciation Rights (SARs): SARs provide the right to the increase in the value of a designated number of shares; such an increase in value is payable in cash or company stock.
- Phantom Stock: this pays a future cash bonus equal to the value of a defined number of shares; no legal transfer of share ownership usually takes place, although the phantom stock may be convertible to actual shares if defined trigger events occur.
- Employee Stock Purchase Plans: these plans give employees the right to purchase company shares, usually at a discount.
In broad terms, the commonality between all these equity compensation plans is that they give employees and stakeholders an equity incentive to build the company and share in its growth and success.
For employees, the key benefits of any type of equity compensation plan are:
- An opportunity to share directly in the company’s success through stock holdings
- Pride of ownership; employees may feel motivated to be fully productive because they own a stake in the company
- Provides a tangible representation of how much their contribution is worth to the employer
- Depending on the plan, it may offer the potential for tax savings upon sale or disposal of the shares
The benefits of an equity compensation plan to employers are:
- It is a key tool to recruit the best and the brightest in an increasingly integrated global economy where there is worldwide competition for top talent
- Boosts employee job satisfaction and financial wellbeing by providing lucrative financial incentives
- Incentivizes employees to help the company grow and succeed because they can share in its success
- May be used as a potential exit strategy for owners, in some instances
There are two main types of ESO:
- Incentive stock options (ISOs), also known as statutory or qualified options, are generally only offered to key employees and top management. They receive preferential tax treatment in many cases, as the IRS treats gains on such options as long-term capital gains.
- Non-qualified stock options (NSOs) can be granted to employees at all levels of a company, as well as to board members and consultants. Also known as non-statutory stock options, profits on these are considered ordinary income and are taxed as such.
Stock options are a benefit often associated with startup companies, which may issue them in order to reward early employees when and if the company goes public. They are awarded by some fast-growing companies as an incentive for employees to work towards growing the value of the company's shares. Stock options can also serve as an incentive for employees to stay with the company. The options are canceled if the employee leaves the company before they vest. ESOs do not include any dividend or voting rights.
There are two key parties in the ESO, the grantee (employee) and grantor (employer). The grantee—also known as the optionee—can be an executive or an employee, while the grantor is the company that employs the grantee. The grantee is given equity compensation in the form of ESOs, usually with certain restrictions, one of the most important of which is the vesting period.
The vesting period is the length of time that an employee must wait in order to be able to exercise their ESOs. Why does the employee need to wait? Because it gives the employee an incentive to perform well and stay with the company. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant.
ESOs are considered vested when the employee is allowed to exercise the options and purchase the company’s stock. Note that the stock may not be fully vested when purchased with an option in certain cases, despite exercising the stock options, as the company may not want to run the risk of employees making a quick gain (by exercising their options and immediately selling their shares) and subsequently leaving the company.
If you have received an options grant, you must carefully go through your company's stock options plan, as well as the options agreement, to determine the rights available and restrictions applied to employees. The stock options plan is drafted by the company’s board of directors and contains details of the grantee’s rights. The options agreement will provide the key details of your option grant such as the vesting schedule, how the ESOs will vest, shares represented by the grant, and the strike price.
If you are a key employee or executive, it may be possible to negotiate certain aspects of the options agreement, such as a vesting schedule where the shares vest faster, or a lower exercise price. It may also be worthwhile to discuss the options agreement with your financial planner or wealth manager before you sign on the dotted line.
ESOs typically vest in chunks over time at predetermined dates, as set out in the vesting schedule. For example, you may be granted the right to buy 1,000 shares, with the options vesting 25% per year over four years with a term of 10 years. So 25% of the ESOs, conferring the right to buy 250 shares would vest in one year from the option grant date, another 25% would vest two years from the grant date, and so on.
If you don’t exercise your 25% vested ESOs after year one, you would have a cumulative increase in exercisable options. Thus, after year two, you would now have 50% vested ESOs. If you do not exercise any of ESOs options in the first four years, you would have 100% of the ESOs vested after that period, which you can then exercise in full or in part. As mentioned earlier, we had assumed that the ESOs have a term of 10 years. This means that after 10 years, you would no longer have the right to buy shares. Therefore, the ESOs must be exercised before the 10-year period (counting from the date of the option grant) is up.
Continuing with the above example, let’s say you exercise 25% of the ESOs when they vest after one year. This means you would get 250 shares of the company’s stock at the strike price. It should be emphasized that the record price for the shares is the exercise price or strike price specified in the options agreement, regardless of the actual market price of the stock.
In some ESO agreements, a company may offer a reload option. A reload option is a nice provision to take advantage of. With a reload option, an employee can be granted more ESOs when they exercise currently available ESOs.
ESOs and Taxation
We now arrive at the ESO spread. As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread.
The following points need to be borne in mind with regard to ESO taxation:
- The option grant itself is not a taxable event. The grantee or optionee is not faced with an immediate tax liability when the options are granted by the company. Note that usually (but not always), the exercise price of the ESOs is set at the market price of the company’s stock on the day of the option grant.
- Taxation begins at the time of exercise. The spread (between the exercise price and the market price) is also known as the bargain element in tax parlance, and is taxed at ordinary income tax rates because the IRS considers it as part of the employee’s compensation.
- The sale of the acquired stock triggers another taxable event. If the employee sells the acquired shares for less than or up to one year after exercise, the transaction would be treated as a short-term capital gain and would be taxed at ordinary income tax rates. If the acquired shares are sold more than one year after exercise, it would qualify for the lower capital gains tax rate.
Let’s demonstrate this with an example. Let’s say you have ESOs with an exercise price of $25, and with the market price of the stock at $55, wish to exercise 25% of the 1,000 shares granted to you as per your ESOs.
The record price would be $6,250 for the shares ($25 x 250 shares). Since the market value of the shares is $13,750, if you promptly sell the acquired shares, you would net pre-tax earnings of $7,500. This spread is taxed as ordinary income in your hands in the year of exercise, even if you do not sell the shares. This feature can create a large tax liability if you continue to hold the stock and it plummets in value due to the exercise.
Let’s recap an important point—why are you taxed at the time of ESO exercise? The ability to buy shares at a significant discount to the current market price (a bargain price, in other words) is viewed by the IRS as part of the total compensation package provided to you by your employer, and is therefore taxed at your income tax rate. Thus, even if you do not sell the shares acquired pursuant to your ESO exercise, you trigger a tax liability at the time of exercise.
Intrinsic Value vs. Time Value for ESOs
The value of an option consists of intrinsic value and time value (extrinsic value). Time value depends on the amount of time remaining until expiration (the date when the ESOs expire) and several other variables. Given that most ESOs have a stated expiration date of up to 10 years from the date of option grant, their time value can be quite significant. While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them.
To calculate the time value for your ESOs, you would have to use a theoretical pricing model like the well-known Black-Scholes option pricing model to compute the fair value of your ESOs. You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO. From there, it is a simple exercise to calculate time value, as can be seen below. Remember that intrinsic value—which can never be negative—is zero when an option is “at the money” (ATM) or “out of the money” (OTM); for these options, their entire value therefore consists only of time value.
The exercise of an ESO will capture intrinsic value but usually gives up time value (assuming there is any left), resulting in a potentially large hidden opportunity cost. Assume that the calculated fair value of your ESOs is $40, as shown below. Subtracting intrinsic value of $30 gives your ESOs a time value of $10. If you exercise your ESOs in this situation, you would be giving up time value of $10 per share, or a total of $2,500 based on 250 shares.
The value of your ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, time to expiration, and above all, volatility. Consider a situation where your ESOs are out of the money (i.e., the market price of the stock is now below the ESOs exercise price).
It would be illogical to exercise your ESOs in this scenario for two reasons. Firstly, it is cheaper to buy the stock in the open market at $20, compared with the exercise price of $25. Secondly, by exercising your ESOs, you would be relinquishing $15 of time value per share. If you think the stock has bottomed out and wish to acquire it, it would be much more preferable to simply buy it at $25 and retain your ESOs, giving you larger upside potential (with some additional risk, since you now own the shares as well).
ESOs vs. Listed Options
The biggest and most obvious difference between ESOs and listed options is that ESOs are not traded on an exchange, and hence do not have the many benefits of exchange-traded options.
The Value of Your ESO Is Not Easy to Ascertain
Exchange-traded options, especially on the biggest stock, have a great deal of liquidity and trade frequently, so it is easy to estimate the value of an options portfolio. Not so with your ESOs, whose value is not as easy to ascertain, because there is no market price reference point. Many ESOs are granted with a term of 10 or more years, but there are virtually no listed options that trade for that length of time. LEAPs (long-term equity anticipation securities) are among the longest-dated options available, but even they only go three years out, which would only help if your ESOs have three years or less to expiration.
Option pricing models are therefore crucial for you to know the value of your ESOs. Your employer is required—on the options grant date—to specify a theoretical price of your ESOs in your options agreement. Be sure to request this information from your company, and also find out how the value of your ESOs has been determined.
Option prices can vary widely, depending on the assumptions made in the input variables. For example, your employer may make certain assumptions about the expected length of employment and estimated holding period before exercise, which could shorten the time to expiration. With listed options, on the other hand, the time to expiration is specified and cannot be arbitrarily changed. Assumptions about volatility can also have a significant impact on option prices. If your company assumes lower than normal levels of volatility, your ESOs would be priced lower. It may be a good idea to get several estimates from other models to compare them with your company’s valuation of your ESOs.
Specifications Are Not Standardized
Listed options have standardized contract terms with regard to the number of shares underlying an options contract, expiration date, etc. This uniformity makes it easy to trade options on any optionable stock, whether it is Apple or Google or Qualcomm. If you trade a call option contract, for instance, you have the right to buy 199 shares of the underlying stock at the specified strike price until expiration.
Similarly, a put option contract gives you the right to sell 100 shares of the underlying stock until expiration. While ESOs do have similar rights to listed options, the right to buy shares is not standardized and is spelled out in the options agreement.
No Automatic Exercise
For all listed options in the U.S., the last day of trading is the third Friday of the calendar month of the option contract. If the third Friday happens to fall on an exchange holiday, the expiration date moves up by a day to that Thursday. At the close of trading on the third Friday, the options associated with that month’s contract stop trading and are automatically exercised if they are more than $0.01 (1 cent) or more in the money. Thus, if you owned one call option contract and at expiration, the market price of the underlying stock was higher than the strike price by one cent or more, you would own 100 shares through the automatic exercise feature.
Likewise, if you owned a put option and at expiration, the market price of the underlying stock was lower than the strike price by one cent or more, you would be short 100 shares through the automatic exercise feature. Note that despite the term "automatic exercise," you still have control over the eventual outcome, by providing alternate instructions to your broker that take precedence over any automatic exercise procedures, or by closing out the position prior to expiration. With ESOs, the exact details about when they expire may differ from one company to the next. Also, as there is no automatic exercise feature with ESOs, you have to notify your employer if you wish to exercise your options.
Listed options have standardized strike prices (exercise prices), coming in increments such as $1, $2.50, $5, or $10, depending on the price of the underlying security (higher-priced stocks have wider increments). With ESOs, since the strike price is typically the stock's closing price on a particular day, there are no standardized strike prices.
In the mid-2000s, an ESO backdating scandal in the U.S. resulted in the resignations of many executives at top firms. This practice involved granting an option at a previous date instead of the current date, thus setting the strike price at a lower price than the market price on the grant date and giving an instant gain to the option holder. ESO backdating has become much more difficult since the introduction of Sarbanes-Oxley as companies are now required to report option grants to the SEC within two business days.
Vesting and Acquired Stock Restrictions
Vesting gives rise to control issues that are not present in listed options. ESOs may require the employee to attain a level of seniority or meet certain performance targets before they vest. If the vesting criteria are not crystal clear, it may create a murky legal situation, especially if relations sour between the employee and employer. As well, with listed options, once you exercise your calls and obtain the stock you can dispose of it as soon as you wish without any restrictions. However, with acquired stock through an exercise of ESOs, there may be restrictions that prevent you from selling the stock.
Even if your ESOs have vested and you can exercise them, the acquired stock may not be vested. This can pose a dilemma, since you may have already paid tax on the ESO Spread (as discussed earlier) and now hold a stock that you cannot sell (or that is declining).
As scores of employees discovered in the aftermath of the 1990s dot-com bust when numerous technology companies went bankrupt, counterparty risk is a valid issue that is hardly ever considered by those who receive ESOs. With listed options in the U.S, the Options Clearing Corporation serves as the clearinghouse for options contracts and guarantees their performance.
Thus, there is zero risk that the counterparty to your options trade will be unable to fulfill the obligations imposed by the options contract. But as the counterparty to your ESOs is your company, with no intermediary in between, it would be prudent to monitor its financial situation to ensure that you are not left holding valueless unexercised options, or even worse, worthless acquired stock.
You can assemble a diversified options portfolio using listed options but with ESOs, you have concentration risk, since all your options have the same underlying stock. In addition to your ESOs, if you also have a significant amount of company stock in your employee stock ownership plan (ESOP), you may unwittingly have too much exposure to your company, a concentration risk that has been highlighted by FINRA.
Valuation and Pricing Issues
The main determinants of an option's value are volatility, time to expiration, the risk-free rate of interest, strike price, and the underlying stock’s price. Understanding the interplay of these variables–especially volatility and time to expiration–is crucial for making informed decisions about the value of your ESOs.
In the following example, we assume an ESO grants the right (when vested) to buy 1,000 shares of the company at a strike price of $50, which is the stock's closing price on the day of the option grant (making this an at-the-money option upon grant). The first table below uses the Black-Scholes option pricing model to isolate the impact of time decay while keeping volatility constant, while the second illustrates the impact of higher volatility on option prices.
As can be seen, the greater the time to expiration, the more the option is worth. Since we assume this is an at-the-money option, its entire value consists of time value. The first table demonstrates two fundamental options pricing principles:
- Time value is a very important component of options pricing. If you are awarded at-the-money ESOs with a term of 10 years, their intrinsic value is zero, but they have a substantial amount of time value, $23.08 per option in this case, or over $23,000 for ESOs that give you the right to buy 1,000 shares.
- Option time decay is not linear in nature. The value of options declines as the expiration date approaches, a phenomenon known as time decay, but this time decay is not linear in nature and accelerates close to option expiry. An option that is far out-of-the-money will decay faster than an option that is at the money because the probability of the former being profitable is much lower than that of the latter.
The table below shows option prices based on the same assumptions, except that volatility is assumed to be 60% rather than 30%. This increase in volatility has a significant effect on option prices. For example, with 10 years remaining to expiration, the price of the ESO increases 53% to $35.34, while with two years remaining, the price increases 80% to $17.45. Further on shows option prices in graphical form for the same time remaining to expiration, at 30% and 60% volatility levels.
Similar results are obtained by changing the variables to levels that prevail at present. With volatility at 10% and the risk-free interest rate at 2%, the ESOs would be priced at $11.36, $7.04, $5.01, and $3.86 with time to expiration at 10, five, three, and two years respectively.
The key takeaway from this section is that merely because your ESOs have no intrinsic value, do not make the naïve assumption that they are worthless. Because of their long time to expiration compared to listed options, ESOs have a significant amount of time value that should not be frittered away through early exercise.
Risk and Reward Associated With Owning ESOs
As discussed in the preceding section, your ESOs can have significant time value even if they have zero or little intrinsic value. In this section, we use the common 10-year grant term to expiration to demonstrate the risk and reward associated with owning ESOs.
When you receive the ESOs at the time of grant, you typically have no intrinsic value because the ESO strike price or exercise price is equal to the stock’s closing price on that day. As your exercise price and the stock price are the same, this is an at-the-money option. Once the stock begins to rise, the option has intrinsic value, which is intuitive to understand and easy to compute. But a common mistake is not realizing the significance of time value, even on the grant day, and the opportunity cost of premature or early exercise.
In fact, your ESOs have the highest time value at grant (assuming that volatility does not spike soon after you acquire the options). With such a large time value component—as demonstrated above—you actually have value that is at risk.
Assuming you hold ESOs to buy 1,000 shares at an exercise price of $50 (with volatility at 60% and 10 years to expiration), the potential loss of time value is quite steep. If the shares are unchanged at $50 in 10 years time, you would lose $35,000 in time value and would be left with nothing to show for your ESOs.
This loss of time value should be factored in when computing your eventual return. Let’s say the stock rises to $110 by expiration in 10 years time, giving you an ESO spread—akin to intrinsic value—of $60 per share, or $60,000 in total. However, this should be offset by the $35,000 loss in time value by holding the ESOs to expiration, leaving a net pre-tax "gain" of just $25,000. Unfortunately, this loss of time value is not tax-deductible, which means that the ordinary income tax rate (assumed at 40%) would be applied to $60,000 (and not $25,000). Taking out $24,000 for compensation tax paid at exercise to your employer would leave you with $36,000 in after-tax income, but if you deduct the $35,000 lost in time value, you would be left with just $1,000 in hand.
Holding ESOs Until Expiration
Before we look at some of the issues surrounding early exercise—not holding ESOs until expiration—let's evaluate the outcome of holding ESOs until expiration in light of time value and tax costs. Below shows the after-tax, net of time value gains and losses at expiration. At a price of $120 upon expiration, actual gains (after subtracting time value) are just $7,000. This is calculated as a spread of $70 per share or $70,000 in total, less compensation tax of $28,000, leaving you with $42,000 from which you subtract $35,000 for time value lost, for a net gain of $7,000.
Note that when you exercise the ESOs, you would have to pay the exercise price plus tax even if you do not sell the stock (recall that exercise of ESOs is a tax event), which in this case equates to $50,000 plus $28,000, for a total of $78,000. If you immediately sell the stock at the prevailing price of $120, you receive proceeds of $120,000, from which you would have to subtract $78,000. The "gain" of $42,000 should be offset by the $35,000 decline in time value, leaving you with $7,000.
Early or Premature Exercise
As a way to reduce risk and lock in gains, early or premature exercise of ESOs must be carefully considered, since there is a large potential tax hit and big opportunity cost in the form of forfeited time value. In this section, we discuss the process of early exercise and explain financial objectives and risks.
When an ESO is granted, it has a hypothetical value that—because it is an at-the-money option—is pure time value. This time value decays at a rate known as theta, which is a square root function of the time remaining.
Assume you hold ESOs that are worth $35,000 upon grant, as discussed in the earlier sections. You believe in the long-term prospects of your company and plan to hold your ESOs until expiration. Below shows the value composition—intrinsic value plus time value—for ITM, ATM, and OTM options.
Value Composition for In-, Out-, and At-the-Money ESO Option With Strike of $50 (Prices in $ Thousands)
Even if you begin to gain intrinsic value as the price of the underlying stock rises, you will be shedding time value along the way (although not proportionately). For example, for an in-the-money ESO with a $50 exercise price and a stock price of $75, there will be less time value and more intrinsic value, for more value overall.
The out-of-the-money options (bottom set of bars) show only pure time value of $17,500, while the at-the-money options have time value of $35,000. The further out of the money that an option is, the less time value it has, because the odds of it becoming profitable are increasingly slim. As an option gets more in the money and acquires more intrinsic value, this forms a greater proportion of the total option value. In fact, for a deeply in-the-money option, time value is an insignificant component of its value, compared with intrinsic value. When intrinsic value becomes value at risk, many option holders look to lock in all or part of this gain, but in doing so, they not only give up time value but also incur a hefty tax bill.
Tax Liabilities for ESOs
We cannot emphasize this point enough—the biggest downsides of premature exercise are the big tax event it induces, and the loss of time value. You are taxed at ordinary income tax rates on the ESO spread or intrinsic value gain, at rates as high as 40%. What’s more, it is all due in the same tax year and paid upon exercise, with another likely tax hit at the sale or disposition of the acquired stock. Even if you have capital losses elsewhere in your portfolio, you can only apply $3,000 per year of these losses against your compensation gains to offset the tax liability.
After you have acquired stock that presumably has appreciated in value, you are faced with the choice of liquidating the stock or holding it. If you sell immediately upon exercise, you have locked in your compensation "gains" (the difference between the exercise price and stock market price).
But if you hold the stock, and then sell it later on after it appreciates, you may have more taxes to pay. Remember that the stock price on the day you exercised your ESOs is now your "basis price." If you sell the stock less than a year after exercise, you will have to pay short-term capital gains tax. To get the lower, long-term capital gains rate, you would have to hold the shares for more than a year. You thus end up paying two taxes—compensation and capital gains.
Many ESO holders may also find themselves in the unfortunate position of holding on to shares that reverse their initial gains after exercise, as the following example demonstrates. Let’s say you have ESOs that give you the right to buy 1,000 shares at $50, and the stock is trading at $75 with five more years to expiration. As you are worried about the market outlook or the company’s prospects, you exercise your ESOs to lock in the spread of $25.
You now decide to sell one-half of your holdings (of 1,000 shares) and keep the other half for potential future gains. Here’s how the math stacks up:
- Exercised at $75 and paid compensation tax on the full spread of $25 x 1,000 shares @ 40% = $10,000
- Sold 500 shares at $75 for a gain of $12,500
- Your after-tax gains at this point: $12,500 – $10,000 = $2,500
- You are now holding 500 shares with a basis price of $75, with $12,500 in unrealized gains (but already tax paid for)
- Let’s assume the stock now declines to $50 before year-end
- Your holding of 500 shares has now lost $25 per share or $12,500, since you acquired the shares through exercise (and already paid tax at $75)
- If you now sell these 500 shares at $50, you can only apply $3,000 of these losses in the same tax year, with the rest to be applied in future years with the same limit
- You paid $10,000 in compensation tax at exercise
- Locked in $2,500 in after-tax gains on 500 shares
- Broke even on 500 shares, but have losses of $12,500 that you can write off per year by $3,000
Note that this does not count the time value lost from early exercise, which could be quite significant with five years left for expiration. Having sold your holdings, you also no longer have the potential to gain from an upward move in the stock. That said, while it seldom makes sense to exercise listed options early, the non-tradable nature and other limitations of ESOs may make their early exercise necessary in the following situations:
- Need for Cashflow: Oftentimes, the need for immediate cashflow may offset the opportunity cost of time value lost and justify the tax impact
- Portfolio Diversification: As mentioned earlier, an overly concentrated position in the company’s stock would necessitate early exercise and liquidation in order to achieve portfolio diversification
- Stock or Market Outlook: Rather than see all gains dissipate and turn into losses on account of a deteriorating outlook for the stock or equity market in general, it may be preferable to lock in gains through early exercise
- Delivery for a Hedging Strategy: Writing calls to gain premium income may require the delivery of stock (discussed in the next section)
Basic Hedging Strategies for ESOs
Basic ESO hedging strategies include writing calls, buying puts, and constructing costless collars. Of these strategies, writing calls is the only one where the erosion of time value in ESOs can be offset by getting time decay working in one’s favor. We strongly recommend that you discuss any hedging strategies with your financial planner or wealth manager. Also review your company’s code of ethics and/or related policies—there may be restricted practices on dealing in options related to your company in which you may be considered an insider.
We use options on the hypothetical XYZ Corp., to demonstrate hedging concepts. Say that XYZ closed at $175.13 on November 15, the date at which time the longest-dated options available on the stock are the three-year calls and puts.
Let’s assume you are an XYZ employee who is granted ESOs to buy 500 shares of the company on Nov. 29, which will vest in 1/3 increments over the next three years, and have 10 years to expiration. For reference, the three-year $175 calls in the market are priced at $32.81 (ignoring bid-ask spreads for simplicity), while the 175 puts trade at $24.05.
Here are three basic hedging strategies, based on your assessment of the stock’s outlook. To keep things simple, we assume that you wish to hedge the potential 500-share long position to just past three years.
- Write Calls: The assumption here is that you are neutral to moderately bullish on XYZ, in which case one possibility to get time value decay working in your favor is by writing calls. While writing naked or uncovered calls can be a very risky business, in this case your short call position would be covered by the 500 shares you can acquire through the exercise of the ESOs. You therefore write five contracts (each contract covers 100 shares) with a strike price of $250, which would fetch you $10.55 in premium (per share), for a total of $5,275 (excluding costs such as commission, margin interest etc.). If the stock goes sideways or trades lower over the next three years, you pocket the premium, and repeat the strategy after three years. If the stock rockets higher and your XYZ shares are "called" away, you would still receive $250 per XYZ share, which along with the $10.55 premium, equates to a return of almost 50%. (Note that your shares are unlikely to be called away well before the three-year expiration because the option buyer would not wish to lose time value through early exercise). Another alternative is to write one call contract one year out, another contract two years out, and three contracts three years out.
- Buy Puts: Let’s say that although you are a loyal XYZ employee, you are a tad bearish on its prospects. This strategy of buying puts will only provide you downside protection, but will not resolve the time decay issue. You think the stock could trade below $150 over the next three years, and therefore buy the three-year $150 puts that are available at $14.20. Your outlay in this case would be $7,100 for five contracts. You would break even if XYZ trades at $135.80 and would make money if the stock trades below that level. If the stock does not decline below $150 within three years' time, you would lose the full $7,100, and if the stock trades between $135.80 and $150 by then you would recoup part of the premium paid. This strategy would not require you to exercise your ESOs and can be pursued as a stand-alone strategy as well.
- Costless Collar: This strategy enables you to construct a collar that establishes a trading band for your XYZ holdings, at no or minimal upfront cost. It consists of a covered call, with part or all of the premium received used to buy a put. In this case, writing the 3-year $215 calls will fetch $19.90 in premium, which can be used to buy the 3-year $165 puts at $19.52. In this strategy, your stock runs the risk of being called away if it trades above $215, but your downside risk is capped at $165.
Of these strategies, writing calls is the only one where you can offset the erosion of time value in your ESOs by getting time decay working in your favor. Buying puts aggravates the issue of time decay but is a good strategy to hedge downside risk, while the costless collar has minimal cost but does not resolve the issue of ESO time decay.
How Do ESOs Differ From Listed Options?
ESOs differ from exchange-traded or listed options in many ways. As they are not traded, their value is not easy to ascertain. Unlike listed options, ESOs do not have standardized specifications or automatic exercise. Counterparty risk and concentration risk are two risks of which ESO holders should be cognizant.
Are ESOs Worthless at First?
Although ESOs have no intrinsic value at option grant, it would be naïve to assume that they are worthless. Because of their lengthy time to expiration compared to listed options, ESOs have a significant amount of time value that should not be frittered away through early exercise.
What Are the Tax Implications of Receiving Employee Stock Options?
While the option grant is not a taxable event, taxation begins at the time of exercise and the sale of acquired stock also triggers another taxable event. Tax payable at the time of exercise is a major deterrent against early exercise of ESOs.
Despite the large tax liability and loss of time value incurred through early exercise, it may be justified in certain cases, such as when cashflow is needed, portfolio diversification is required, the stock or market outlook is deteriorating, or stock needs to be delivered for a hedging strategy using calls.
The Bottom Line
ESOs are a form of equity compensation granted by companies to their employees and executives. Like a regular call option, an ESO gives the holder the right to purchase the underlying asset—the company’s stock—at a specified price for a finite period of time. ESOs are not the only form of equity compensation, but they are among the most common.
Stock options are of two main types. Incentive stock options, generally only offered to key employees and top management, receive preferential tax treatment in many cases, as the IRS treats gains on such options as long-term capital gains. Non-qualified stock options (NSOs) can be granted to employees at all levels of a company, as well as to board members and consultants. Also known as non-statutory stock options, profits on these are considered to be ordinary income and are taxed as such.
ESO holders should be familiar with their company’s stock options plan as well as their options agreement to understand any restrictions and clauses therein. Employees should also be familiar with their company's code of ethics or professional conduct policies They should also consult their financial planner or wealth manager to gain the maximum benefit of this potentially lucrative component of compensation.