Meaning; Employees Stock Option [s] (ESOs) are call options on a company’s common stock granted to a select group of its employees. What does Employees Stock Option mean? with Motivating Employees; Here, the employee has the right, but not the obligation to buy the company’s shares at a specific time and a specific date.
Define ESOs by Wikipedia below; Employees stock option is 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. Regulators and economists have since specified that ESOs are compensation contracts.
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.
In the United States, the terms are detailed within an employer’s “Stock Option Agreement for Incentive Equity Plan”. Essentially, this is an agreement which grants the employee eligibility to purchase a limited amount of stock at a predetermined price. The resulting shares that are granted are typically restricted stock. There is no obligation for the employee to exercise the option, in which case the option will lapse.
The Employees Stock Options or ESOs is the compensation scheme, wherein the specified employees or executives are granted a certain number of shares of the company. Here, the employee has the right, but not the obligation to buy the company’s shares at a specific time and a specific date. – by Business Jargons.
According to Investopedia,
“An employees stock option that grants specified employees of a company the right to buy a certain amount of company shares at a predetermined price for a specific period. An employee stock option differs slightly from an exchange-traded option because it is not traded between investors on an exchange.”
Employees stock option plan is a company-wide incentives plan whereby the company contributes shares of its own stock or cash to be used to purchase such stock to a trust established to purchase shares of the firm’s stock for employees. The firm generally makes these contributions annually in proportion to total employee compensation, with a limit of 15% of compensation.
The trust holds the stock in individual employee accounts, and distributes it to employees upon retirement, assuming the person has worked long enough to earn ownership of the stock. Many companies use employee stock options plans to retain and attract employees, the objective being to give employees an incentive to behave in ways that will boost the company’s stock price.
By issuing employees stock option as compensation, organizations can preserve and generate cash flow. The cash flow comes when the organizations issue new shares and receives the exercise price and receives a tax deduction equal to the fair market value of the shares that are transferred to the trustee, and can also claim a tax deduction for dividends paid on ESO-owned stock.
Employees aren’t taxed until they receive a distribution from the trust, usually at retirement when their rate is lower. The Employee Retirement Income Security Act (ERISA) allows a firm to borrow against employee stock held in trust and then repay the loan in pretax rather than after-tax dollars, another tax incentive for using such plans.
Employees will have an incentive to work hard for the company as they become the owner of the share, so there is a good chance for the employee to take more responsibility and regarding performance, they put up more effort to get the upper hand. They will want to put the goals of the company ahead of their own and will be willing to work harder to make their stock options become more valuable.
This puts employees in an ownership position, and they will treat the business as if it were their own. This can also help the shareholders of the closely held corporation to diversify their assets by placing some of the company’s stock into the ESO trust and purchasing other marketable securities for themselves in their place. Many business owners find that offering stock options to employees improves morale.
When employees are given a share of ownership in the company, they will enjoy coming to work. They know that their efforts will directly impact their financial situation and will be more willing to work together. Instead of looking at the situation as the employees against the employer, they will look at the situation as if everyone were working towards a common goal. There are some drawbacks which may face by the company when using the employee stock options as a compensation strategy, such as lack of diversification.
An employee stock option often leads employees to rely too heavily on them for their financial success. A wise approach to investing would involve diversifying your available resources over several different types of investments. Many employees who have access to stock options will put everything they have into them. This puts a lot of pressure on the company to succeed.
When employees are relying on the company for their retirement, it changes the responsibilities for everyone. Another disadvantage of offering the employee stock options is that employees may loss of focus. In some cases, when the company offers stock options to employees before the company goes public, they could potentially lose focus on the job at hand.
Sometimes, the price of a company’s stock goes up significantly during an IPO. When this happens, the employees that have the stock options might be more concerned with the value of the stock options than focusing on their job. This could potentially lead to lost profits shortly after the IPO is completed. Moreover, the management encourages the employees to take high risk. As far as employees are concerned stock option in form of compensation is an undue risk.
In case of an unstable company, if large numbers of employees try to exercise the option to get profit in the market then there is a chance of collapse in the whole equity structure of a company. When the company issues additionally new shares to the other investors, there is no chance for the other investors to get the upper hand as it increases the outstanding shares. In such a case the company must either repurchase stock or increase its earnings which may help in forestalling the dilution of value.
If an employee working for company XYZ gets an option on 100 XYZ shares at $10 and XYZ’s stock price goes up to $20, the employee can exercise the option and buy the 100 XYZ shares at the $10 strike price, sell them on the market for $20 each, and pocket the $1,000 difference ($2,000 – $1,000 = $1,000). If XYZ’s stock never goes above the $10 strike price, the employee lets the option expire at no real cost to themselves.
There are two types of employee stock option: incentive stock options (ISO’s) and nonqualified stock options (NQSO’s). ISO’s are usually given to upper management while NQSO’s are generally provided to other employees or service providers. While NQSO’s can be obtained at a discount to the stock value, ISO’s generally enjoy more favorable tax treatment. The employee does not have to provide any cash to obtain these stocks. Introduction to Public Finance, Expenditure, Revenue, and Debt.
The employees stock option is different from the exchange-traded options in the sense these are not traded on the secondary market and hence do not have any marketable value.
Also, there is no put option in case of ESOs. Often, the employee stock option is given to the employees as a reward for their performance and as a means of motivation for higher productivity.