Employee Stock Options

By Abhijeet Talapatra Priyanka Menon Manali Lande

Flow of the Presentation ‡ ‡ ‡ ‡ ‡ ‡ ‡ What is ESO? Need for ESO Features of ESOs Types of ESOs Tax Benefits Valuation of ESO Pros and Cons .

.What is ESO? Definition: A stock option granted to specified employees of a company . but not the obligation. to buy a certain amount of shares in the company at a predetermined price. ESOs carry the right. OR An employee stock option is a Warrant on a company's own stock issued as a form of non-cash compensation .

‡ ESOs are mostly offered to management as part of their executive compensation package. issued as a form of non-cash compensation. holders of options generally experience a direct financial benefit..What is ESO? Contd. ‡ Restrictions on the option align the holder's interest with those of the business' shareholders. ‡ An ESO is a call option on the common stock of a company. ‡ If the company's stock rises. .

How do they get their employees to make decisions that help the stock price increase? ‡ ESOs are a powerful motivator. because payoffs to options can be large..Need For ESO  Owners of a corporation (i. .e. the stockholders) have a basic problem. ‡ ESOs have no upfront costs to the company. ‡ High stock prices: ESO holders gain and shareholders gain.

‡ Therefore.Need For ESO Contd ‡ ESOs can be viewed as a substitute for ordinary wages. ESOs are helpful in recruiting employees. categorized as capital gain (only 50% taxable) . ‡ Personal tax incentive ± No income taxed until exercised ± When taxed.

Features of ESOs ‡ There is a vesting period during which options cannot be exercised ‡ When employees leave during the vesting period options are forfeited ‡ When employees leave after the vesting period in-the-money options are exercised immediately and out of the money options are forfeited ‡ Employees are not permitted to sell options .

.Features Contd. ‡ When options are exercised the company issues new shares ‡ To realize cash from an employee stock option the employee must exercise the options and sell the underlying shares .

Employee stock-purchase plans (EPPs) Qualify for favorable tax treatment . 2.Enable employees to turn their work earnings into company investments via a structured offer-andpurchase schedule 3. Incentive Stock Options (ISOs) pay certain employees. for good performance ‡ .gives employees the chance to contribute their own funds to the company.Types of ESOs Three options allow employees to tie their investment earnings to shareholder profit: 1. Non-qualified Options : Do not qualify for favorable tax treatment . such as executives.

Tax Benefits ‡ ESO Plans may be treated as capital gains instead of compensation income ‡ The gain made upon sale or transfer--the difference between the agreed strike price and the stock price is considered a capital gain. ‡ Options bought or sold earlier are treated as income. . ‡ Non-qualified options gains as income regardless of when you buy and sell. ‡ Benefits of a better tax rate when you hold onto an investment. ‡ Options bought at least one year from the grant date and transfer at least two years from this date qualify for the favorable tax treatment.

Valuation of ESO .

.Pros and Cons ‡ Advantages :  Increases employee loyalty and commitment to the organization.  Companies are not required to record options pending as an expense.  Employees become owners with a financial stake in the company's performance. not the company.  "Granting options enables managers to pay employees with an IOU rather than cash with the prospect that the stock market. will one day pay up .  Stock options also offer tax advantages to businesses.  Talented employees will be attracted to the company. and will be inclined to stay in order to reap the future rewards.

 Rewarding executives excessively in the boom market.  Failure to penalize bad performance by resetting option price in the down market  Encouraging executives to take excessive risks at the cost of the shareholders. .‡ Disadvantages:  The difficulty of accounting.  The opportunity cost of options for the granting firm higher than the value of options to undiversified executives. expensing options in particular.  Giving executives extra incentives to manipulate accounting information.

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