Employee Stock Options: Definitions and Key Concepts

Before delving into the finer details of Employee Stock Options (ESOs), it is crucial to have an understanding of basic option terms. Here’s a brief description of 10 key option terms you should know.

Call Option: Also known simply as a “Call,” a call option gives the buyer the right but not the obligation to buy the underlying security or asset at a certain price within a defined period of time. The call buyer thus benefits when the underlying security or asset increases in price.

(Option) Exercise: For a call buyer, option exercise means executing the right to buy the underlying security at the exercise price or strike price. For a put buyer, option exercise means executing the right to sell the underlying security at the exercise price or strike price.

Exercise Price or Strike Price: The price at which the underlying asset can be purchased (for a call option) or sold (for a put option); the exercise price or strike price is determined at the time of formation of the option contract.

Expiration Date: The last day of validity for an options contract, after which it expires worthless. The time left to expiration is a key determinant of the price of an option; in general terms, the longer the time to expiration, the higher the option price.

In the money (ITM):  A term that indicates the option has intrinsic value, i.e. for a call option, the market price of the underlying security is higher than the exercise price, and for a put option, the market price is lower than a put option. Conversely, an option is said to be “out of the money” (OTM) if the market price of the underlying is lower than the exercise price for a call option, or the market price is higher than the exercise price for a put option. An option is said to be “at the money” (ATM) if the market price of the underlying is equal to the exercise price for a call option, as well as for a put option. 

Intrinsic Value: A call has intrinsic value if the market price of the underlying asset is higher than the exercise price. A put has intrinsic value if the market price of the underlying asset is lower than the exercise price.

Option Premium: The price paid by an option buyer to the option seller or “writer,” generally quoted on a per-share basis. The premium is paid up front by the buyer at the time of option purchase and is not refundable.

Spread: The difference between the market price of the underlying security and the exercise price of the option, at the time of exercise.

Time Value: One of the two components – along with intrinsic value – of an option’s price or premium, time value is any premium in excess of an option’s intrinsic value. For an option with zero intrinsic value, the full premium is attributable to time value.

Underlying (Asset): The financial asset or security on which an option’s price is based, and which must be delivered to the option buyer upon exercise.

Now let’s look specifically at ESOs, and begin with the participants – the grantee (employee) and grantor (employer). The grantee – also known as the optionee – can be an executive or an employee, while the grantor is the company that employs the grantee. The grantee is given equity compensation in the form of ESOs, usually with certain restrictions, one of the most important of which is the vesting period.

The vesting period is the length of time that an employee must wait in order to be able to exercise his or her ESOs. Why does the employee need to wait? Because it gives the employee an incentive to perform well and stay with the company. Vesting follows a pre-determined schedule that is set up by the company at the time of the option grant.

Vesting

ESOs are considered vested when the employee is allowed to exercise the options and purchase the company’s stock. Note that the stock may not be fully vested in certain cases, despite exercise of the stock options, as the company may not want to run the risk of employees making a quick gain (by exercising their options and immediately selling their shares) and subsequently leaving the company. 

If you are in line for an options grant, you must carefully go through your company’s stock options plan, as well as the options agreement, to determine the rights available and restrictions applied to employees. The stock options plan is drafted by the company’s Board of Directors and contains details of the grantee’s rights. The options agreement will provide the key details of your option grant such as the vesting schedule, how the ESOs will vest, shares represented by the grant, and the exercise or strike price. If you are a key employee or executive, it may be possible to negotiate certain aspects of the options agreement, such as a vesting schedule where the shares vest faster, or a lower exercise price. It may also be worthwhile to discuss the options agreement with your financial planner or wealth manager before you sign on the dotted line.

ESOs typically vest in chunks over time at pre-determined dates, as set out in the vesting schedule. For example, you may be granted the right to buy 1,000 shares, with the options vesting 25% per year over four years with a term of 10 years. So 25% of the ESOs, conferring the right to buy 250 shares would vest in one year from the option grant date, another 25% would vest two years from the grant date, and so on.

If you don’t exercise your 25% vested ESOs after year one, you would have a cumulative increase in exercisable options; thus after year two, you would now have 50% vested ESOs. If you do not exercise any of ESOs options in the first four years, you would have 100% of the ESOs vested after that period, which you can then exercise in full or in part. As mentioned earlier, we had assumed that the ESOs have a term of 10 years. This means that after 10 years, you would no longer have the right to buy shares; therefore, the ESOs must be exercised before the 10-year period (counting from the date of the option grant) is up.

Paying for the Stock

Continuing with the above example, let’s say you exercise 25% of the ESOs when they vest after one year. This means you would get 250 shares of the company’s stock at the strike price.  

It should be emphasized that the price you have to pay for the shares is the exercise price or strike price specified in the options agreement, regardless of the actual market price of the stock. Withholding tax and other related state and federal income taxes are deducted at this time by the employer, and the purchase price will typically include these taxes in the stock price purchase cost.

You would need to come up with the cash to pay for the stock. This is a nice problem to have, especially if the market price is significantly higher than the exercise price, but it does mean that you may have a cash-flow issue in the short term.

Cash exercise – wherein payment has to be made in cash for shares purchased by exercise of an ESO – is the only route for option exercise allowed by some employers. However, other employers now allow cashless exercise, which involves an arrangement made with a broker or other financial institution to finance the option exercise on a very short-term basis, and then have the loan paid off with the immediate sale of all or part of the acquired stock. 

The ESO Spread and Taxation

We now arrive at the ESO Spread. Since the acquired stock can be immediately sold in the market at the prevailing price, the higher the market price is from the exercise price, the larger the “spread” and hence the compensation (not the “gain”) earned by the employee. As will be seen later, this triggers a tax event whereby ordinary income tax is applied to the spread.

The following points need to be borne in mind with regard to ESO taxation (see Get The Most Out Of Employee Stock Options):

• The option grant itself is not a taxable event. The grantee or optionee is not faced with an immediate tax liability when the options are granted by the company. Note that usually (but not always), the exercise price of the ESOs is set at the market price of the company’s stock on the day of the option grant.
• Taxation begins at the time of exercise. The spread (between the exercise price and the market price) is also known as the bargain element in tax parlance, and is taxed at ordinary income tax rates because the IRS considers it as part of the employee’s compensation.
• The sale of the acquired stock triggers another taxable event. If the employee sells the acquired shares for less than or up to one year after exercise, the transaction would be treated as a short-term capital gain and would be taxed at ordinary income tax rates. If the acquired shares are sold more than one year after exercise, it would qualify for the lower capital gains tax rate.

Let’s demonstrate this with an example. Let’s say you have ESOs with an exercise price of $25, and with the market price of the stock at $55, wish to exercise 25% of the 1,000 shares granted to you as per your ESOs.

You would therefore need to pay $6,250 (ignoring taxes for the moment) for the shares ($25 x 250 shares). Since the market value of the shares is $13,750, if you promptly sell the acquired shares, you would net pre-tax earnings of $7,500. This spread is taxed as ordinary income in your hands in the year of exercise, even if you do not sell the shares. This aspect can give rise to the risk of a huge tax liability, if you continue to hold the stock and it plummets in value, as thousands of workers in the technology sector discovered in the aftermath of the 2000-02 “tech wreck” (see “Tech workers stock options turn into tax nightmares’’). 

Let’s recap an important point – why are you taxed at the time of ESO exercise? The ability to buy shares at a significant discount to the current market price (a bargain price, in other words) is viewed by the IRS as part of the total compensation package provided to you by your employer, and is therefore taxed at your income tax rate. Thus, even if you do not sell the shares acquired pursuant to your ESP exercise, you trigger a tax liability at the time of exercise.

Table 1: Example of ESO Spread and Taxation

Intrinsic Value vs. Time Value for ESOs

The value of an option consists of intrinsic value and time value. Time value depends on the amount of time remaining until expiration (the date when the ESOs expire) and several other variables. Given that most ESOs have a stated expiration date of up to 10 years from the date of option grant, their time value can be quite significant. While time value can be easily calculated for exchange-traded options, it is more challenging to calculate time value for non-traded options like ESOs, since a market price is not available for them.

 To calculate the time value for your ESOs, you would have to use a theoretical pricing model like the well-known Black-Scholes option pricing model (see ESOs: Using the Black-Scholes Model) to compute the fair value of your ESOs. You will need to plug inputs such as the exercise price, time remaining, stock price, risk-free interest rate, and volatility into the Model in order to get an estimate of the fair value of the ESO. From there, it is a simple exercise to calculate time value, as can be seen in Table 2. Remember that intrinsic value – which can never be negative – is zero when an option is “at the money” (ATM) or “out of the money” (OTM); for these options, their entire value therefore consists only of time value.

The exercise of an ESO will capture intrinsic value but usually gives up time value (assuming there is any left), resulting in a potentially large hidden opportunity cost. Assume that the calculated fair value of your ESOs is $40, as shown in Table 2. Subtracting intrinsic value of $30 gives your ESOs a time value of $10. If you exercise your ESOs in this situation, you would be giving up time value of $10 per share, or a total of $2,500 based on 250 shares.

Table 2: Example of Intrinsic Value and Time Value (In the Money ESO)

The value of your ESOs is not static, but will fluctuate over time based on movements in key inputs such as the price of the underlying stock, time to expiration, and above all, volatility. Consider a situation where your ESOs are out of the money, i.e. the market price of the stock is now below the ESOs exercise price (Table 3).

Table 3: Example of Intrinsic Value and Time Value (Out of the Money ESO)

It would be illogical to exercise your ESOs in this scenario for two reasons. Firstly, it is cheaper to buy the stock in the open market at $20, compared with the exercise price of $25. Secondly, by exercising your ESOs, you would be relinquishing $15 of time value per share. If you think the stock has bottomed out and wish to acquire it, it would be much more preferable to simply buy it at $25 and retain your ESOs, giving you larger upside potential (with some additional risk, since you now own the shares as well).