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This article may be too technical for most readers to understand. Please help improve it to make it understandable to non-experts, without removing the technical details. The examples and perspective in this article deal primarily with the United States and do not represent a worldwide view of the subject. Employee stock options are commonly viewed as a complex call option on the common stock of a company, granted by the company to an employee as part of the employee’s remuneration package. These nonstandard contracts exist between employee and employer, whereby the employer has the liability of delivering a certain number of shares of the employer stock, when and if the employee stock options are exercised by the employee. The contract length varies, and often carries terms that may change depending on the employer and the current employment status of the employee.
AICPA’s Financial Reporting Alert describes these contracts as amounting to a “short” position in the employer’s equity, unless the contract is tied to some other attribute of the employer’s balance sheet. To the extent the employer’s position can be modeled as a type of option, it is most often modeled as a “short position in a call. Many companies use employee stock options plans to retain, reward, and attract employees, the objective being to give employees an incentive to behave in ways that will boost the company’s stock price. The employee could exercise the option, pay the exercise price and would be issued with ordinary shares in the company.
Stock options are also used as golden handcuffs if their value has increased drastically. An employee leaving the company would also effectively be leaving behind a large amount of potential cash, subject to restrictions as defined by the company. Another substantial reason that companies issue employee stock options as compensation is to preserve and generate cash flow. The cash flow comes when the company issues new shares and receives the exercise price and receives a tax deduction equal to the “intrinsic value” of the ESOs when exercised. Employee stock options are offered differently based on position and role at the company, as determined by the company. Management typically receives the most as part of their executive compensation package.
ESOs may also be offered to non-executive level staff, especially by businesses that are not yet profitable, insofar as they may have few other means of compensation. Over the course of employment, a company generally issues employee stock options to an employee which can be exercised at a particular price set on the grant day, generally a public company’s current stock price or a private company’s most recent valuation, such as an independent 409A valuation commonly used within the United States. Exercise price: The exercise price is non-standardized and is usually the current price of the company stock at the time of issue. Alternatively, a formula may be used, such as sampling the lowest closing price over a 30-day window on either side of the grant date. On the other hand, choosing an exercise at grant date equal to the average price for the next sixty days after the grant would eliminate the chance of back dating and spring loading. Quantity: Standardized stock options typically have 100 shares per contract. ESOs usually have some non-standardized amount.