Stock Based Compensation - ESO
ESO, or employee stock option, is a contract that gives employees the right to buy a specific number of shares of company stock at a specified price called the strike price, within a particular time frame known as the exercise window. Although some of the rules that regulate stock options are imposed by tax and securities laws, others are at the company’s discretion. This allows people to buy shares of a company at an attractive price, oftentimes below market price.
There are various types of ESOs and with that comes different requirements in terms of taxes, disbursement, and corporate structure. One reason companies use stock options as a form of compensation is to retain employees. Some features of ESOs are more beneficial to an employee the longer they work for the company. Additionally, companies can use ESOs to distribute equity of the company, preserving their cash flow. Each company can determine how and to whom ESOs are offered.
Types of ESOs
Equity-classified awards are when the employee has the right to receive equity shares of a company. The amount is measured as the fair value of the shares of the company on the grant date.
Liability-classified awards are when an employee receives cashed based on the value of shares in the agreed upon stock-based compensation plan.
In the United States, most employee stock options are non-transferable and often cannot be immediately exercised, meaning turned into shares. In the U.S., the most common type of stock options, are non-qualified stock options, and are taxed as standard income when they are exercised. Incentive stock options are subject to alternative minimum tax but are not taxed as standard income.
Non-Qualified Stock Options
Non-qualified stock options or (NSOs) can be granted to employees at all levels of a company, as well as to board members and consultants. NSOs are taxed as income for the person who receives the NSO. The corporation is allowed a tax deduction for every dollar the recipient receives in their income.
There are special rules for deferred compensation, known as IRC 409Al. Read it here
Incentive Stock Options
ISOs, or incentive stock options, are a type of employee stock compensation that has some special rules that apply both to the company and the recipient of the option. Specifically, if the recipient of the option does not pay standard taxes (employment or income) on the difference between the exercise price or strike price. ISOs are usually only awarded to top management and highly valued employees. Additionally, ISOs holders are responsible for any long-term capital gain and alternative minimum Tax they may owe if shares are not sold in the same year.
Vesting Period
Vesting is an important concept in the realm of stock compensation. The vesting period refers to the length of time that an employee must wait before they can exercise their ESOs. The period is pre-determined by the company at the grant date. Typically, ESOs vest overtime at predetermine dates and rates. For example, you may be given the option to buy 100 shares, you could vest 25 percent over 4 years, meaning you could buy 25 shares in the company each of the four years.
Risks of Owning ESOs
ESOs have the highest time value at grant (if volatility does not spike soon after you acquire the options). A common mistake is not realizing the significance of time value, even on the grant day, and the opportunity cost of premature or early exercise. The employee has the choice after the option has vested to exercise their option or not. This choice is usually dependent on the market price of the company shares, as the employee will only want to purchase the option if the price is equal to or less then the market price. With such a large time value component it is important to incorporate the time value of money concept when understanding how the value of your options changes overtime indirectly with its stock price.
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