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: Basic Hedging Strategies
  8. Employee Stock Options: Conclusion

Employee stock options (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 as ordinary income and are taxed as such.  (Related: How Are Futures & Options Taxed?)

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.

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.

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.

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.

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.

ESO holders should be familiar their company’s stock options plan as well as their options agreement to understand restrictions and clauses therein. They should also consult their financial planner or wealth manager to gain the maximum benefit of this potentially lucrative component of compensation.

 


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