Make Money With Stock Options – Employee stock options (ESO) refer to a form of equity compensation that companies provide to their employees and managers. Rather than issuing stock directly, the company offers derivative options on the stock. These options come in the form of regular call options and give employees the right to purchase shares of the company at a specified price over a specified period of time. The terms of ESOs are fully specified for employees in the employee stock options contract.
In general, the greatest benefit of stock options occurs when the company’s stock rises above its strike price. Generally, ESOs are issued by the company and cannot be sold unlike standard trading or barter options. When the stock price exceeds the exercise price of the call option, the call option is exercised and the shareholder receives the company’s shares at a discount. Shareholders can sell the shares immediately or hold the shares over time to make a profit on the open market.
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Company benefits for some or all employees may include a stock compensation plan. These schemes are known to offer financial compensation in the form of shares. ESOs are a form of equity compensation that a company can issue. Other types of capital compensation include:
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Generally speaking, the common denominator among all these equity compensation plans is that they provide employees and shareholders with a financial incentive to start the company and have a stake in the company’s growth and success.
Stock options are benefits often associated with start-ups that reward employees early and can be granted if the company goes public. It is offered by some fast-growing companies as an incentive to employees trying to increase the value of company stock. Stock options provide an incentive for employees to stay with the company. The option is revoked before the employee leaves the company. ESOs do not carry any dividends or voting rights.
There are two main parties in an ESO, the donor (employee) and the donor (employer). The donor – also called the recipient – can be a manager or employee, while the donor is the organization that employs the donor. Grants are compensated in the form of ESOs, usually with capital with certain restrictions, one of which is vesting period.
The authorization period is the period during which employees must wait to use their ESO. Why should employees wait? Because it motivates employees to perform better and stay in the company. When given the option, it follows a predetermined schedule set by the company.
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ESOs are considered earned when employees are allowed to exercise options and buy company stock. Sometimes when buying options, the entire stock may not be covered, and even if stock options are exercised, the company may not want to take the risk of employees earning faster (by exercising their options and selling their shares immediately) and then leaving the company.
If you receive an option grant, you should carefully review your company’s stock option plan and option agreement to determine the benefits and restrictions that apply to employees. A stock option plan is prepared by the company’s board of directors and the rights of the grantors are explained. The option agreement will provide key details of your option grant, such as the vesting period, how the ESOs are vested, the shares represented by the grant, and the strike price.
If you are a key employee or manager, you may be able to negotiate certain aspects of the option contract, such as an earlier equity vesting plan or lower labor costs. Before you sign the dotted line, it may be helpful to discuss an options settlement with your financial planner or asset manager.
ESOs usually qualify in installments over a predetermined period defined in the vesting schedule. For example, with a 10-year maturity, you can purchase 1,000 shares with an annual 25% option for four years. Thus, if 25% of ESOs grant the right to purchase 250 shares, the option is vested for one year from the date of issue and the other 25% is vested for two years from the date of issue.
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If you have not used 25% of your ESOs at the end of one year, you will have the option to use the increase. So, after two years you will now receive 50% ESO. If you do not apply any ESO in the first four years, after that period you will receive 100% ESO, which you can apply in whole or in part. As mentioned earlier, we assume that ESOs will last for 10 years. This means that after 10 years you will not have the right to buy the shares. Therefore, ESOs must be used within a 10-year period (from the date the option was granted).
Continuing from the example above, let’s say after a year you have done 25% of the exercises in ESOs. This means you buy 250 shares of the company at the strike price. It should be emphasized that the record price of the stock is the strike price or strike price specified in the option contract, regardless of the actual market price of the stock.
For certain ESO contracts, Company may offer reload options. A great feature to take advantage of is the reload option. With the reload option, employees can earn more ESO while using their existing ESO.
Now we come to the distribution of ESO. As will be seen later, this creates a tax event in which ordinary income tax is applied to the distribution.
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Let’s see this with an example. Let’s say you have an ESO with a strike price of $25 and the stock price is $55 and you want to use 25% of the 1,000 shares issued to you based on your ESOs.
The subscription price will be $6,250 per share ($25 x 250 shares). Since the shares have a market value of $13,750, if you sell the shares immediately, your pre-tax net income will be $7,500. Even if you do, the stock will still be taxed as ordinary income in your possession. Do not sell shares. If you continue to hold the stock and it loses value due to use, this feature can create a large tax liability.
Let’s summarize the key points – why are you taxed when using ESO? The ability to purchase the stock at a significant discount at the current market price (aka bargain price) is viewed by the IRS as part of the total compensation package your employer gives you and is therefore subject to your income tax. Vote. Therefore, even if you do not sell the shares you receive when you use your ESO, you are subject to tax liability when you use it.
The value of an option consists of its intrinsic value and its time value (extrinsic value). The time value depends on the time to maturity (the date ESOs expire) and many other variables. The time values can be quite significant as most ESOs have a fixed expiration date of up to 10 years from the date the option was granted. For exchange-traded options, time value can be easily calculated, while for non-traded options such as ESOs, time value is more difficult to calculate because market prices are not available for them.
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To calculate the time value of your ESOs, you should use a theoretical pricing model, such as the popular Black-Scholes option pricing model, to calculate the fair value of your ESOs. To estimate the fair value of an ESO, you must include inputs such as strike price, remaining time, stock price, risk-free interest rate, and model volatility. From there, calculating the time value as seen below is a simple exercise. Note that the intrinsic value – cannot be negative – is zero when the option is “at the money” (ATM) or “out of the money” (OTM); The total value for these options is the time value only.
ESO implementation captures intrinsic value but often gives up time value (assuming it remains), resulting in large hidden opportunity costs. Let’s assume the calculated fair value of your ESO is $40, as shown below. Subtract the real value of $30 and your ESOs have a time value of $10. If you use your ESOs in this scenario, you will lose $10 per share or a total of $2,500 based on 250 shares.
The value of your ESO is not fixed but fluctuates over time