Often misunderstood, Employee Stock Options are given by companies to their Employees as part of a compensation package.
The come with a set of rules and restrictions that Employees need to know in order to manage them properly.
This article will explain everything you need to know about your Employee Stock Options plan.
Employee Stock Options Explained: What Is It ?
Employee Stocks Options are a way for companies to recruit and compensate their employees.
Their introduction can be tracked back to the 1950s.
Who did it first? You might think it was a technology company that awarded the first stock option, but it was actually the pharmaceutical giant Pfizer that first issued broad-based statutory stock options in 1952. But use of common stock to recruit, retain and reward employees was pretty unusual.
Stock options had begun an ascent in popularity in the late 1980s, particularly among technology companies that were on the verge of the dot.com boom, but also among well-known companies, such as Pepsi, Wendy’s, Bank of America and Citigroup.
At the time, any publicly traded company could just award employee stock options plan since the process does not require any sort of real capital.
Since these early days, corporations now have to become more creative is issuing these plans because of accounting rules changes that force them to treat as an Earnings charge or expenses.
In the dot.com era, it became common practice for start-ups in order to attract and retain talented workers.
From CEOs to C-Suite executives, stock options became a way to ensure that key individuals within the companies will not be poached by the companies.
Employee Stock Options Explained: How Does It Work ?
Let’s illustrate wants to hire a highly qualified person who is in high demand.
I could be a C-suite or just a regular employee.
They will lure this person with “X” Employee stock options with a strike price and a vesting period.
The terms here are almost similar to the stock exchange options lingo.
X represents the number of Shares the Employee Will take ownership of after the Vesting period
The vesting Period if the time typically in years (1,2 or 3-5 years) during which these stock Options cannot be exercised
Exercising means taking ownership of the shares of that particular stock.
Before that, the employee ONLY has the “option” to the stocks after they said employee abide by the rule of the grant.
In the vast majority of cases, that rule is simply to maintain employment with the company.
Importance of the Strike Price
There are multiples scenarios.
In the dot.com boom era, for not yet publicly traded companies, the strike price would be $0.
This means that as long the employees were to maintain employment with the company for the entire duration of the vesting period and assuming the company went public, the employees became rightful owners of “X” shares. As simple as that.
If the company is publicly traded, certain C-suite can get Employee stock options at 100% discount especially at the start of employment. This technique is often used as part of the signing bonus package.
Meaning, meet the vesting period and they would own “X”.
The chart below from the Accounting Politic Institute gives us an idea of the portion of CEO compensation that is from stock options from 2007 through early 2017.
The study was conducted based on 350 US largest firms.
We can clearly see that the lion shares of the compensation for these 350 CEOs in this study comes from Employee Equity awards.
For general employees, the discount may not be as favorable as for C-suite ones.
The setup may be the same though.
Suppose the com[any stock is trading of the public stock exchange at $100.
The company can issue Employee stock options for $50 strike price or 50% discount.
After the vesting period, if the price of the stock is above the strike price of $50, employee can safely exercise the stock options to realize a profit.
The preferred method to take profits in this context is a cashless exercise.
How does it work ?
Your brokerage firm will lend you the money to buy your shares at $50 because they know that the current market price of the stock is much higher.
This is a very short term long.
Right after the execution of the buy of your shares, another transaction will follow immediately where you will sell the very same shares at the market price.
If the market price is $100, you will make roughly 50% profit minus the fees and the short term loan from your brokerage firm.
Vesting Period per Tranches
Sometimes, the employee stock options can have a scaled vesting time of the type:
33% vested after the first year
50% after the second year
Remaining 50 after the third year
Any combination of the above can be determined by the plan.
Frequently Asked Questions
Now that you have a better idea what employee stocks options are, here are some of the questions those holding them may need to know.
When will I receive my shares ?
After the vesting period and the exercise when the market price is above the strike price.
When Can I exercise my Employee Stock Options
After the vesting period. Assuming the Options can be exercised.
When Can I sell my Employee Stock Options ?
As early as at the end of the vesting period through a cashless exercise for instance.
How Long Can I Hold my stock Options ?
As long as you would like.
Do I have to Pay Taxes on my Stock Options ?
Yes. Short Term Capital Gains are due at the time of your tax filing.
Long Term Capital Gains if the shares are held for more than 1 year.
Consult your Tax Specialist with all Tax related inquiries.
We presented the Employee stock options concept and the different scenarios they may present.
We learned through this discussion that they are quite different from the “trading” stocks options we have been learning about here.
We hope you found this information valuable.
If you you like to return to learning about the stock market standard day-today Options tutorials, click here.
Instead, if you would like to check out some of our videos tutorials, use this link.