Alu employee stock options

Fast Answers.

Many companies use employee stock options plans to compensate, retain, and attract employees. These plans are contracts between a company and its employees that give employees the right to buy a specific number of the company’s shares at a fixed price within a certain period of time. The fixed price is often called the grant or exercise price. Employees who are granted stock options hope to profit by exercising their options to buy shares at the exercise price when the shares are trading at a price that is higher than the exercise price.

Companies sometimes revalue the price at which the options can be exercised. This may happen, for example, when a company’s stock price has fallen below the original exercise price. Companies revalue the exercise price as a way to retain their employees.

If a dispute arises about whether an employee is entitled to a stock option, the SEC will not intervene. State law, not federal law, covers such disputes.

Unless the offering qualifies for an exemption, companies generally use Form S-8 to register the securities being offered under the plan. On the SEC’s EDGAR database, you can find a company’s Form S-8, describing the plan or how you can obtain information about the plan.

Employee stock options plans should not be confused with the term "ESOPs," or employee stock ownership plans, which are retirement plans.

Employee Stock Option - ESO.

What is an 'Employee Stock Option - ESO'

An employee stock option (ESO) is a stock option granted to specified employees of a company. ESOs offer the options holder the right to buy a certain amount of company shares at a predetermined price for a specific period of time. An employee stock option is slightly different from an exchange-traded option, because it is not traded between investors on an exchange.

BREAKING DOWN 'Employee Stock Option - ESO'

How a Stock Option Agreement Works.

Assume that a manager is granted stock options, and the option agreement allows the manager to purchase 1,000 shares of company stock at a strike price, or exercise price, of $50 per share. 500 shares of the total vest after two years, and the remaining 500 shares vest at the end of three years. Vesting refers to the employee gaining ownership over the options, and vesting motivates the worker to stay with the firm until the options vest.

Examples of Stock Option Exercising.

Using the same example, assume that the stock price increases to $70 after two years, which is above the exercise price for the stock options. The manager can exercise by purchasing the 500 shares that are vested at $50, and selling those shares at the market price of $70. The transaction generates a $20 per share gain, or $10,000 in total. The firm retains an experienced manager for two additional years, and the employee profits from the stock option exercise. If, instead, the stock price is not above the $50 exercise price, the manager does not exercise the stock options. Since the employee owns the options for 500 shares after two years, the manager may be able to leave the firm and retain the stock options until the options expire. This arrangement gives the manager the opportunity to profit from a stock price increase down the road.

Factoring in Company Expenses.

ESOs are often granted without any cash outlay requirement from the employee. If the exercise price is $50 per share and the market price is $70, for example, the company may simply pay the employee the difference between the two prices multiplied by the number of stock option shares. If 500 shares are vested, the amount paid to the employee is ($20 X 500 shares), or $10,000. This eliminates that need for the worker to purchase the shares before the stock is sold, and this structure makes the options more valuable. ESOs are an expense to the employer, and the cost of issuing the stock options is posted to the company's income statement.

Understanding Employee Stock Options.

Does your new job offer stock options to you? For many it's a great incentive to join a new company. Google (GOOG) has to be the highest-profile example, with the legendary stories of thousands of original employees becoming multi-millionaires, including the in-house masseuse. Below is some information to help you understand stock options a little better if you’re confused about how they work.

Though employee stock options have lost a bit of their luster since the global financial meltdown -- being replaced more and more by restricted stock -- options still account for nearly one-third of the value of executive incentive packages, according to compensation consulting firm James F. Reda & Associates. Want stock options? You’re going to find them harder to find these days, mainly due to changes in the tax laws and recent blow-back from employees working for companies battered by the recession and tired of holding out-of-the-money, worthless options. In fact, employee stock options peaked in popularity back in 1999.

But if you score a gig with options, here’s how it will work.

Being granted stock options gives you the right to buy your company’s stock for a set price at a future date and for a specified time. We’ll use GOOG as an example.

Let’s say you were among those lucky “Nooglers” hired back when GOOG was issuing stock options at $500. You get the right to buy 1000 shares at $500 (the grant price ) after two years (the vesting period) and you have ten years to exercise the options (buy the shares).

If Google’s stock price is under $500 when your shares are vested they are out of the money and you’re out of luck. You don’t have to buy the shares at a loss, they just expire worthless, unless the stock rebounds and gets above its strike price -- or if the company generously decides to revalue the original exercise price.

But if GOOG is over $1000, as it is now, crack open the champagne – you’re in the money! You can buy 1000 shares at $500, then sell them and pocket a half million dollar profit. Just watch out for the ensuing tax bill.

In some cases, you can exercise your options and then hold on to the stock for at least a year before selling them and pay a lower tax rate. Options have a bunch of tax consequences to consider. If you have questions about your stock options, ask an advisor.

The downside of employee stock options.

In spite of that fact that options can make millionaires out of masseuses, there are some downsides:

Stock options can be a bit complicated. For example, different kinds of stock options have different tax consequences. There are non-qualified options and incentive stock options (ISOs), both having specific tax triggers. Options can expire worthless. Imagine the thrill of a grant followed by the agony of a stock flop. Rather than acting as an employee incentive, options issued for a stumbling stock can muck-up morale. Knowing when and how to exercise stock options can be nerve wracking. Has the stock reached its peak? Will it ever rebound from historic lows? Exercise and hold – or exercise and sell? And you can get way too invested in company stock. Holding a heap of options can lead to a windfall or a downfall. You just can’t bank on them until they’re in the money and in your pocket.

Employee stock options can be an extraordinary wealth-builder. With a rising company stock price and a vesting ladder, it’s almost like a forced savings account. And that can be an option worth taking.

Neda Jafarzadeh is a financial analyst for NerdWallet, a site dedicated to helping investors make better financial decisions with their money.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of NASDAQ, Inc.

How Employees Value (Often Incorrectly) Their Stock Options.

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One of the more intriguing changes in executive and employee compensation is the increase in the use of stock options. Although much of the discussion about stock options has focused on “new economy” companies, there has been a corresponding increase in stock options grants for more traditional firms as well. The typical explanation for the use of stock options is that these compensation vehicles enable companies to attract and retain the best employees and also provide superior incentives for employees to increase shareholder value.

While these explanations seem reasonable on the surface, they hinge on the assumption that employees understand how stock options work. Yet according to recent research by Wharton professors David F. Larcker and Richard A. Lambert , employees, in fact, tend not to understand the basic economics of stock options – a finding that has important implications for employees, employers, boards of directors and management consultants.

Larcker’s and Lambert’s research, based on a survey of 122 KnowledgeWharton readers conducted in March 2001, looked at what stock options cost the firm and at what value employees place on them. “For example, we found that some employees harbor unrealistic expectations as to what will happen to the stock price,” says Larcker. “In other words, the employees value their options more than they are theoretically worth, which can cause human resource problems as well as raise certain ethical issues.”

An earlier survey, this one conducted in May 2000 by OppenheimerFunds Inc., came up with some of the same conclusions although its scope was more limited. The survey, based on 107 respondents who owned stock options, found, for example, that 39% of option holders said they knew “little” or “nothing” about their options and another 35% said they knew only “something.” As a strong indication of serious knowledge limitations, 11% of the respondents had allowed “in the money” options to expire, essentially rendering them worthless. Finally, 52% said they knew “little” or “nothing” about the tax implications of exercising options.

A Primer on Stock Options.

What stock prices will be five to ten years in the future are, of course, unknown at the grant date. As a result, many firms rely on a valuation model to determine the cost of granting an option. One common valuation methodology is the Black-Scholes approach, which is easy to compute with widely available programs and provides a reasonable indication of the expected cost to the firm of granting a stock option. For a typical company, the Black-Scholes value of an executive stock option granted at the money – where the grant price is the same as the stock price on that date – is 30% to 50% of the current stock price.

Although the cost to the firm can be reasonably estimated, the value of the stock option to an employee is not simply the Black-Scholes value. This is because the wealth of employees is much more highly tied to the value of the firm than is the wealth of well-diversified outside investors. Employees, who are contractually forbidden from selling their options to outside investors, therefore have less ability to hedge the risk associated with holding options, and they are more likely to exercise options early for both liquidity and risk reduction reasons.

In general, the value of a stock option to a risk-averse employee can be substantially below the firm’s cost of granting the stock option. Thus, the value of a stock option to an employee should not exceed the Black-Scholes value of the option.

Black-Scholes and other similar models provide theoretical figures for the cost of the option to the firm or the upper bound to the value of the option to the employee. However, almost nothing is known about how employees actually value their stock options. The key issue is, “What do employees perceive an option to be worth?” Providing an answer to that question has profound implications for designing compensation programs.

It was also one of the questions asked by the Larcker and Lambert survey, conducted with iQuantic Inc. The survey participants were managers or top-level executives from 98 different firms. The typical respondent was 36 years of age, had been employed by his or her company for five years, earned cash compensation of $135,000 and held equity in their company of $50,000. The typical respondent had been granted options three times by his current firm and had exercised options once.

Given the timing of the survey, it is not surprising that stock prices of many of the respondents’ firms had fallen during the previous year; the average one-year stock price return (volatility) preceding the survey went down 50%, and the average volatility was 98%. However, the respondents thought that their firm’s stock price during the next year would increase by an average of 96%. So, despite poor recent stock price performance and high volatility, the respondents appeared very optimistic about the future.

The survey asked the respondents to provide an answer to the question, “How much cash would your company have to offer you per option to return a fully vested stock option with seven years life remaining”? In other words, “what is that option worth to you?” Five different scenarios of exercise price and current stock price were examined (in decreasing level of value): stock options that are in the money by 100% (i. e. the current stock price is double the option’s exercise price), in the money by 10%, at the money (i. e. the grant price is the same as the stock price at that date), out of the money by 10%, and out of the money by 50% (i. e. the current stock price is half of the option’s exercise price).

The results, shown in a graph , revealed that managers value their options substantially above the Black-Scholes value. For example, at-the-money options are valued at 50% higher than the Black-Scholes value and options that are out-of-the-money by 50% are valued at more than double the Black-Scholes value. These results, says Lambert, “indicate that managers do not fully understand the value of stock options or possibly their associated incentive effects.”

Further analysis revealed that younger employees at low managerial positions have the most upward bias in the perceived values. In addition, employees who exercised options during the past year and have higher expectations for future stock price performance place higher values on their stock options. Consistent with traditional economics, employees who are highly risk averse (or have a strong dislike of volatility in their wealth) place a much higher value on in-the-money stock options and a much lower value on out-of-the-money stock options. Finally, says Larcker, there is some preliminary evidence that men do a slightly better job valuing stock options than women.

In several instances multiple employees from the same firm responded to the survey. The results for a firm engaged in software development and consulting are presented as are the results for a firm engaged in computer hardware manufacturing . With some exceptions, the respondents valued their options above the upper bound computed from Black-Scholes. Moreover, these figures revealed that employees generally do understand how the value of a stock option decreases as the option falls further out of the money. The figures also demonstrated that there is substantial variation in the perceived value within managers of the same company. “The extent of this heterogeneity is problematic for understanding whether stock options provide the same incentives across the organization,” says Lambert.

Implications for Firms.

Moreover, the training program needs to be tailored to the bias associated with specific employee characteristics. For example, younger employees in technical areas may have a different set of problems understanding stock options than senior-level managers in marketing.

Then there is what Larcker calls “more devious behavior – the idea that firms can cut back the number of options granted to employees in order to satisfy wage requirements.” For example, assume that the expected economic value of a stock option is $20, but the employee overvalues the same stock option at (say) $40. In addition, assume that the employee requires stock option value of $10,000 per year. How many options would satisfy the employee: $10,000/$40 = 250? Clearly, the firm is using the bias of the employee in order to pay him or her less (the employee should demand $10,000/$20 = 500 options, and not 250 options).

The goal of this research is to understand how employees value stock options and to identify the factors that cause employees to over-value or under-value their options. If you are interested in surveying a broad cross-section of your employees about how they value their options, please contact David Larcker ( larckerwharton. upenn. edu ) or Richard Lambert ( lambertwharton. upenn. edu) .

To see a sample report from this survey (best viewed using the Internet Explorer browser) click here .

Citing KnowledgeWharton.

For Personal use:

accessed December 21, 2017. knowledge. wharton. upenn. edu/article/how-employees-value-often-incorrectly-their-stock-options/

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