Employee stock options (ESOs) are a form of equity compensation that some companies offer to their employees and executives. ESOs give the right to buy a certain number of shares of the company’s stock at a predetermined price, within a specified period of time. ESOs are usually granted as an incentive to attract, retain, and motivate employees, as well as to align their interests with those of the shareholders.
But where do the shares that are issued to the employees come from? How do they affect the company’s capital structure and valuation? And what are the benefits and drawbacks of ESOs for both the company and the employees? In this article, we will answer these questions and explain the basics of ESOs.
How ESOs Work
ESOs are a type of call option, which means that they give the holder the right, but not the obligation, to buy the underlying asset (in this case, the company’s stock) at a specified price (called the strike price or exercise price) before or on a certain date (called the expiration date).
ESOs are typically granted to employees at the time of hiring or promotion, or as part of their annual compensation package. The grant date is the date when the employee receives the option contract and becomes eligible to exercise it. However, the employee cannot exercise the option right away. ESOs usually have a vesting period, which is the time that the employee has to wait before they can exercise their options. The vesting period can range from a few months to several years, depending on the company’s policy and the employee’s position. The vesting schedule can be either cliff vesting, which means that the employee can exercise all of their options at once after the vesting period ends, or graded vesting, which means that the employee can exercise a portion of their options gradually over the vesting period.
Once the employee’s options are vested, they can decide whether to exercise them or not, depending on the market price of the stock and their personal financial situation. If the market price of the stock is higher than the strike price of the option, the employee can exercise their option and buy the stock at a discount, and then either hold or sell the stock for a profit. This is called being in the money. If the market price of the stock is lower than the strike price of the option, the employee can choose not to exercise their option and let it expire worthless. This is called being out of the money. If the market price of the stock is equal to the strike price of the option, the employee is indifferent between exercising or not exercising their option. This is called being at the money.
ESOs usually have an expiration date, which is the last day that the employee can exercise their option. The expiration date can vary from a few months to several years after the grant date, depending on the company’s policy and the employee’s position. If the employee does not exercise their option before the expiration date, the option expires and becomes worthless.
Where Do the Shares Come From?
When an employee exercises their option, they buy the shares of the company’s stock at the strike price. But where do these shares come from? There are two main sources of shares for ESOs: authorized shares and treasury shares.
Authorized shares are the maximum number of shares that a company can issue, as specified in its articles of incorporation. A company can issue new shares from its authorized shares to fulfill its ESO obligations. However, issuing new shares can dilute the ownership and earnings per share of the existing shareholders, as well as increase the company’s share capital and legal costs. Therefore, a company may need to obtain the approval of its board of directors and shareholders before issuing new shares for ESOs.
Treasury shares are the shares that a company has issued and then repurchased from the market. A company can use its treasury shares to fulfill its ESO obligations, without affecting its authorized shares or diluting its existing shareholders. However, using treasury shares can reduce the company’s cash flow and assets, as well as increase its share repurchase costs. Therefore, a company may need to balance its treasury share usage with its cash management and capital structure objectives.
Benefits and Drawbacks of ESOs
ESOs can have both benefits and drawbacks for both the company and the employees. Some of the benefits of ESOs are:
- For the company, ESOs can help attract, retain, and motivate talented employees, as well as align their interests with those of the shareholders. ESOs can also reduce the company’s cash compensation expenses and tax liabilities, as ESOs are generally not taxable until they are exercised.
- For the employees, ESOs can provide an opportunity to share in the company’s growth and success, as well as diversify their income and wealth. ESOs can also offer flexibility and leverage, as the employees can choose when and how to exercise their options, and benefit from the upside potential of the stock price without risking their own capital.
Some of the drawbacks of ESOs are:
- For the company, ESOs can create dilution and complexity in the company’s capital structure and valuation, as well as increase the company’s accounting and reporting requirements and costs. ESOs can also create agency problems and conflicts of interest, as the employees may have different risk preferences and time horizons than the shareholders, and may engage in opportunistic or unethical behaviors to manipulate the stock price or the option terms.
- For the employees, ESOs can create uncertainty and risk in their compensation and wealth, as ESOs are contingent on the company’s performance and the stock market conditions. ESOs can also create tax and liquidity issues, as the employees may face a high tax burden and cash outlay when they exercise their options, and may have difficulty selling their shares in the market or diversifying their portfolio.
Conclusion
Employee stock options are a form of equity compensation that some companies offer to their employees and executives. ESOs give the right to buy a certain number of shares of the company’s stock at a predetermined price, within a specified period of time. ESOs are usually granted as an incentive to attract, retain, and motivate employees, as well as to align their interests with those of the shareholders.
The shares that are issued to the employees when they exercise their options can come from two main sources: authorized shares and treasury shares. Authorized shares are the maximum number of shares that a company can issue, as specified in its articles of incorporation. Treasury shares are the shares that a company has issued and then repurchased from the market. A company may need to balance the advantages and disadvantages of using either source of shares for its ESO obligations.
ESOs can have both benefits and drawbacks for both the company and the employees. ESOs can help attract, retain, and motivate talented employees, as well as align their interests with those of the shareholders. ESOs can also provide an opportunity to share in the company’s growth and success, as well as diversify their income and wealth. However, ESOs can also create dilution and complexity in the company’s capital structure and valuation, as well as increase the company’s accounting and reporting costs. ESOs can also create uncertainty and risk in the employees’ compensation and wealth, as well as tax and liquidity issues.
ESOs are a complex and dynamic form of compensation that require careful planning and management from both the company and the employees. ESOs can be a valuable and rewarding tool for both parties, if they are designed, implemented, and exercised in a fair, transparent, and efficient manner.
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