Employee Stock Options

Employee stock options (ESOs) are contracts between a company and its employees, which gives the employee the right to buy a certain number of the company’s shares at a fixed price within a

certain time frame. ESOs are used to compensate, retain, and attract employees to and within the company. Those who are granted employee stock options hope to profit by exercising their options when the shares are trading at a price higher than the exercise price. (SEC, 2014). Types of stock granted can be: common stock, restricted stock or restricted stock units. Start-ups use ESOs to bring in founding team members, to recruit, compensate and retain early employees, and allow employees to share in the company’s long-term upside. Employee stock option plans tend to outline how shares will be distributed, and what the terms govern these grants. The plan is very important in planning and regulation, as companies do not want to be in a situation where all available employee stock options have been allocated to current employees with none reserved for future. (Accion, 2017).

When ESOs are granted, the price that the employee can purchase the stock is called the grant or exercise price. In companies that are publicly listed, it is normally the closing market price of the stock on the day that it is granted. In companies that are not publicly traded, often the fair market value of a share needs to be calculated to determine the exercise price. Each ESO grant will have an expiration date, which is the last the holder of options can exercise. The expected expiration date is used to calculate the cost of employee exercise to the company. (Olagues &

Summa, 2010, p. 7). Numerous ESOPs have a vesting period, which requires the employee to stay at the company for a specific period after they are granted. Normally it is uniformed, an equal percentage split over n years (uniformed), but the vesting period can be a cliff, an employee gaining full benefit after a certain amount of time, front ended, majority of the options being released closer to grant date, or back ended, majority being released at the end of the vesting period, or performance based (Ernest Young India, 2014, p. 15). In addition to vesting periods, it is standard to have transferability clauses barring the transfer of options. It is also quite common for them to be non-pledgable for loans or liabilities. (Olagues & Summa, 2010, p. 8).

Whether stock options are considered employee ownership is debated. Those who believe ESOs are considered employee stock ownership believe because the employee must pay something to exercise the options (the exercise price), they are in fact owning the stock. Those on the opposite side believe because once options are granted, employees can sell reasonably fast, therefore it does not contribute to long term ownership attitudes. The attitude that the company granting has towards the option plan, long term attitude and visions, and education they provide through the plan has a large effect on how the employees view the options: as purely just options or as

ownership in the firm. (NCEO, 2017). Key issues that need to be addressed prior to implementing an ESOP are displayed in Table 1.

Table 1. Key issues that should be addressed in employee stock option plans.

Key Issue Explanation

Total number of shares An ESOP must reserve a maximum number of shares to be issued, typically ranging 5-20% of the total shares of a company.

Number of options granted to an employee

How will this amount be established?

Plan administration Who will be in charge of administering the plan?

Consideration How will the exercise price be paid on exercise of the options? Will it be taken out of salary or paid by cash?

Shareholder approval Plans should be approved by shareholders prior to implementing.

Right to terminate employment

Although plans are made to encourage employee participation and retention, it should be clearly noted that option grants are not synonymous with lifelong employment.

Vesting Time period that the employee must wait before exercising partial or all options.

Exercise price How much does the employee have to pay for the stock when they exercise? The value of the option can be determined either by the value of the stock trading the day it was granted or a FMV valuation of the company.

Time to exercise How long does the employee have the right to exercise?

Transferability restrictions Can the options be transferred? It is normal that options and underlying stock are nontransferable; however, it can be customized depending on the company

Securities law compliance Each ESOP must be compliant with federal and state securities laws.

409A valuation (in the USA)

Values the company at fair market value to determine the exercise price. This adheres to section 409A of the Internal Revenue Code.

Type of stock Will the ESOs be incentive stock options or non-qualified stock options? The stock type affects taxation upon exercise.

(Harroch, 2016) All key issues stated above should be recorded and understood among top management before implementing an ESOP. This prevents misconceptions and issues that can arise once options are implemented.

2.1.1 Employee Stock Options in the USA and Europe

In the 1990s, employee stock options were considered to be the most popular form of executive employee long term equity reward in the United States of America. This was due to the market moving significantly and the large rewards from them. (Bachelder III, 2014). Today in the USA, the popularity of stock options as executive pay has fallen due to three major events: the 2006 change of accounting legislation, 2008 banking crisis, and the Dodd-Frank Act which gave the Institutional Shareholder Services Inc. (ISS), a greater influence on executive pay. However with the fall of popularity as forms of executive pay, stock options have boomed as incentive plans in technology start-ups thanks to their prevalence in the Silicon Valley. Approximately today, 7.2%

of employees hold stock options. (NCEO, 2017).

There has been initiatives to increase employee share ownership in the European Union. These share ownership programs consist of: individual employee share ownership (shares or options), employee stock ownership plans, and profit sharing. Overall in the European Union, approximately 5.2% of firms have employee stock ownership. This was nearly a 10% increase from the early 2000s. (Lowtizsch & Hashi, 2014, p. 1). Employee stock ownership plans are much less common in the EU than in the USA. They are still considered to have unexploited potential, with current studies supporting the hypothesis that firms where employee ownership is present see increases in productivity and employment. But unlike the USA, where states are in the same country, in the EU it is much harder to implement cross border employee ownership plans due to the differences in regulatory density and fiscal treatments of existing schemes (Lowtizsch & Hashi, 2014, p. 2).

The European Commission hopes to promote the adoption of employee ownership schemes throughout the EU.