Stock Compensation

 A stock option is a grant to an employee of the right to buy a certain

number of shares in the company's stock for a set price at a future date.
If the stock price increases above the options price, the employee gets
benefitted.

 Employee stock options are a form of equity compensation granted by

companies as an incentive for employees.

 Stock options serve as an incentive for employees to stay with the

company. The options are canceled if the employee leaves the company
before they vest.

 Stock options in themselves do not give the employee shareholder rights

such as dividends or votes. If a company awards stock options, the
terms and conditions are generally set out in the company’s ESOP.
2
 An employer who grants stock options awards the employee a
number of options at a set price (the "strike price" or "exercise
price"). The options may be exercised after a specified date.
They are "vested" at that date, meaning ownership of the
options is transferred to the employee.

 If the stock price has increased, the employee may buy shares
at the strike price and sell them at the market price, pocketing
the difference. Some companies complete the deal directly with
their employees to save them the trouble and expense of the
market transaction.

 Unlike listed or exchange-traded options, employee stock are

issued by the company and cannot be sold. It is called
restricted stock option.

 ESOs are an expense to the employer, and companies post the

cost of issuing the stock options to their income statements.

3
Key Terms and Variables

 Exercise: The purchase of stock pursuant to an option.

 Grant date - date at which the options are granted to the
employee
 Exercise price/ grant price/ strike price - price at which
employee can buy the stock
 expected life - expected time from grant date to exercise
 Vesting period - period after which the employee first becomes
eligible to exercise the options
 Expiration period - period after which the options lapse (i.e., can
no longer be exercised)
 volatility - variance of the firm’s stock price
 Spread: The difference between the exercise price and the market
value of the stock at the time of exercise.

4
Volatility is a function of (exercise price, volatility, expected
life, stock price, market interest rate).

Implied volatility is a prediction made by market participants of

the degree to which underlying securities move in the future.
Implied volatility is essentially the real-time estimation of an
asset’s price as it trades.

Historic volatility measures the speed at which underlying

asset prices change over a given time period. Historical
volatility is often calculated annually, but because it constantly
changes, it can also be calculated daily and for shorter time
frames.

Paul Zarowin 5
Benefits of ESOPs for the employers

With the help of ESOP options, organizations could avoid the cash
compensations as a reward, thus saving on immediate cash
outflow. For organizations which are starting their business
operations on a bigger scale or expanding their business, awarding
their employees with ESOPs would work out to be the most
feasible option than the cash rewards.

6
ESOPs from an employee’s perspective

With ESOPs, an employee gets the benefit of acquiring the shares

of the company at the nominal rate, and sell them (after a defined
tenure set by his employer) and make a profit.

There are several success stories of an employee raking in the

riches together with founders of the companies. A very notable
example is of Google when it went public. Its founders Sergey Brin
and Larry Page became the richest persons in the world, even the
stock-holder employees earned millions too.

7
Tax Implication of ESOPs

While exercising – in form of a prerequisite. When an employee exercises his option,

the difference between Fair Market Value (FMV) as on date of exercise and the
exercise price is taxed as a perquisite.

While selling – in the form of capital gain. An employee might sell his shares after
buying them. In case he sells these shares at a price higher than FMV on the
exercise date, he would be liable for capital gains tax.

8
Example of a Stock Option
 On Jan. 1st 2015, company A grants one of its
employee an option to purchase 2,000 stocks:
 Vesting period of 3 years

 Exercise price $55

 Duration 10 years

 He was supposed to pay only $55 x 2000 =

$1,10,000

 Price on Jan 2019 is $120

 Employee profit: ($120-$55) x 2,000 =$130,000
 Earning $120x2000 = $2,40,000
9
In,Out and At the Money Options
Options can be:
 “In the money”, i.e., the exercise price is below

the current stock price.

 “Out of the money”, i.e., the exercise price is

above the current stock price.

 “At the money”, i.e., the exercise price is the

same as the current stock price.

 Employees’ stock options are typically granted at the

money.

10
Accounting for Employees’ Stock Options

Firms have choice of 2 methods:

1. IV (Intrinsic Value) Method

method most firms use to account for stock options: only
recognize compensation expense if exercise price < market
price @ grant date

2. FV (Fair Value) Method

recognize compensation expense @ grant date equal to the
FV of the options at that date.

11
 Advantages of Restricted Stock Units

 RSUs give an employee an incentive to stay with a

company long term and help it perform well so that their
shares increase in value. If an employee decides to hold
their shares until they receive the full vested allocation,
and the company's stock rises, the employee receives the
capital gain minus the value of the shares withheld for
income taxes and the amount due in capital gains taxes.
 Administration costs are minimal for employers as there
aren't actual shares to track and record. RSUs also allow a
company to defer issuing shares until the vesting schedule
is complete, which helps delay the dilution of its shares.

12
 Limitations of Restricted Stock Units

 RSUs don't provide dividends, as actual shares are not allocated.

Restricted stock is included in gross income for tax purposes, and it is
recognized on the date when the stocks become transferrable (also
known as the vesting date).

 RSUs don't have voting rights until actual shares get issued to an
employee at vesting. If an employee leaves before the conclusion of
their vesting schedule, they forfeit the remaining shares to the
company. For instance, if John's vesting schedule consists of 5,000
RSUs over two years and he resigns after 12 months, he forfeits 2,500
RSUs.

13