what is an employee stock option 
an employee stock option eso is a type of equity compensation granted by companies to their employees and executives rather than granting shares of stock directly the company gives options on the stock instead esos are call options that give the employee the right to buy the company s stock at a specified price for a finite period of time terms of esos will be fully spelled out for an employee in an employee stock options agreement typically esos cannot be sold unlike standard listed or exchange traded options in general the greatest benefit of a stock option is realized if the price of a company s stock rises above the call option exercise price when this happens call options are exercised and the holder obtains the company s stock at a discount the employee may choose to immediately sell the stock in the open market for a profit or hold onto the stock over time investopedia sydney saporitounderstanding employee stock optionscorporate benefits for some or all employees may include equity compensation plans these plans are known for providing financial compensation in the form of stock equity esos are just one type of equity compensation a company may offer there are two main types of eso in broad terms esos and other types of equity compensation plans give employees and stakeholders an equity incentive to build a company and share in its growth and success for employees esos and any other type of equity compensation plan offer key benefits for employers esos stock options are a benefit often associated with startup companies which may issue them in order to reward early employees when and if the company goes public they are awarded by some fast growing companies as an incentive for employees to work towards growing the value of the company s shares stock options can also serve as an incentive for employees to stay with the company the options are canceled if the employee leaves the company before they vest esos do not include any dividend or voting rights important conceptsthere are two key parties to the eso the grantee employee and grantor employer the grantee also known as the optionee can be an executive or another 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 before they can exercise their esos the waiting time serves as an incentive to the employee 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 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 when purchased with an option in certain cases despite exercising the stock options 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 stock options plan and agreementif you receive an options grant carefully review 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 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 it vesting exampleesos typically vest in chunks over time on predetermined 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 the 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 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 record price for the shares is the exercise price or strike price specified in the options agreement regardless of the actual market price of the stock in some eso agreements a company may offer a reload option which offers employees an additional attractive benefit with a reload option an employee can be granted more esos when they exercise currently available esos esos and taxationwe now arrive at the eso spread which is the difference between the exercise price and the market price as we ll see later ordinary income tax is applied to this spread the following points need to be borne in mind with regard to eso taxation let s say you have esos with an exercise price of 25 when the market price of the stock reaches 55 you decide to exercise 25 of the 1 000 shares granted to you the record price would be 6 250 for the shares 25 x 250 shares since the market value of the shares is 13 750 55 x 250 shares if you promptly sell the acquired shares you would net pre tax earnings of 7 500 13 750 6 250 this spread 7 500 is taxed as ordinary income in your hands in the year of exercise even if you do not sell the shares this feature can create a large tax liability if you continue to hold the stock and it plummets in value due to the exercise 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 eso exercise you trigger a tax liability at the time of exercise image by sabrina jiang investopedia 2020intrinsic value vs time value for esosthe value of an option consists of intrinsic value and time value extrinsic 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 will use a theoretical pricing model like the well known black scholes option pricing model to compute the fair value of your esos you will need 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 below 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 this results in a potentially large hidden opportunity cost assume that the calculated fair value of your esos is 40 as shown below 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 image by sabrina jiang investopedia 2020the 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 image by sabrina jiang investopedia 2020it would be illogical to exercise your esos in this scenario for two reasons first it is cheaper to buy the stock in the open market at 20 compared with the exercise price of 25 and second 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 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 in broad terms esos and other types of equity compensation plans give employees and stakeholders an equity incentive to build a company and share in its growth and success esos vs listed optionsthe biggest and most obvious difference between esos and listed options is that esos are not traded on an exchange and hence do not have the many benefits of exchange traded options exchange traded options especially on the biggest stocks have a great deal of liquidity and trade frequently so it is easy to estimate the value of an options portfolio not so with your esos because there is no market price reference point many esos are granted with a term of 10 or more years but there are virtually no listed options that trade for that length of time leaps long term equity anticipation securities are among the longest dated options available but even they only go three years out which would only help if your esos have three years or less to expiration 2therefore option pricing models are needed to value your esos your employer is required on the options grant date to specify a theoretical price of your esos in your options agreement be sure to request this information from your company and also find out how the value of your esos has been determined option prices can vary widely depending on the assumptions made in the input variables for example your employer may make certain assumptions about the expected length of employment and estimated holding period before exercise which could shorten the time to expiration with listed options on the other hand the time to expiration is specified and cannot be arbitrarily changed assumptions about volatility can also have a significant impact on option prices if your company assumes lower than normal levels of volatility your esos would be priced lower it may be a good idea to get several estimates from other models to compare them with your company s valuation of your esos while esos do have similar rights to listed options the right to buy shares is not standardized and is spelled out in the options agreement listed options have standardized contract terms concerning the number of shares underlying an options contract expiration date etc this uniformity makes it easy to trade options on any optionable stock whether it is apple or google or qualcomm for instance if you trade a call option contract you have the right to buy 100 shares of the underlying stock at the specified strike price until expiration similarly a put option contract gives you the right to sell 100 shares of the underlying stock until expiration with esos the exact details about when they expire may differ from one company to the next also there is no automatic exercise feature you have to notify your employer if you wish to exercise your options for all listed options in the u s the last day of trading is the third friday of the calendar month of the option contract if the third friday happens to fall on an exchange holiday the expiration date moves up by a day to that thursday 3 at the close of trading on the third friday the options associated with that month s contract stop trading and are automatically exercised if they are more than 0 01 1 cent or more in the money 4thus if you owned one call option contract and at expiration the market price of the underlying stock was higher than the strike price by one cent or more you would own 100 shares through the automatic exercise feature likewise if you owned a put option and at expiration the market price of the underlying stock was lower than the strike price by one cent or more you would be short 100 shares through the automatic exercise feature note that despite the term automatic exercise you still have control over the eventual outcome you can provide alternate instructions to your broker that take precedence over any automatic exercise procedures or you can close out your position prior to expiration listed options have standardized strike prices exercise prices coming in increments such as 1 2 50 5 or 10 depending on the price of the underlying security higher priced stocks have wider increments with esos since the strike price is typically the stock s closing price on a particular day there are no standardized strike prices in the mid 2000s an eso backdating scandal in the u s resulted in the resignations of many executives at top firms this practice involved granting an option at a previous date instead of the current date thus setting the strike price at a lower price than the market price on the grant date and giving an instant gain to the option holder eso backdating has become much more difficult since the introduction of the sarbanes oxley act as companies are now required to report option grants to the sec within two business days 5vesting gives rise to control issues that are not present for listed options esos may require the employee to attain a level of seniority or meet certain performance targets before they vest if the vesting criteria are not crystal clear it may create a murky legal situation especially if relations sour between the employee and employer in addition with listed options once you exercise your calls and obtain the stock you can dispose of it as soon as you wish without any restrictions however with acquired stock through an exercise of esos there may be restrictions that prevent you from selling the stock even if your esos have vested and you can exercise them the actual acquired stock may not be vested this can pose a dilemma since you may have already paid tax on the eso spread as discussed above and now hold a stock that you cannot sell or that is declining as scores of employees discovered in the aftermath of the 1990s dot com bust when numerous technology companies went bankrupt counterparty risk is a valid issue that is hardly ever considered by those who receive esos for listed options in the u s the options clearing corporation serves as the clearinghouse for options contracts and guarantees their performance 6 thus there is zero risk that the counterparty to your options trade will be unable to fulfill the obligations imposed by the options contract but as the counterparty to your esos is your company with no intermediary in between it would be prudent to monitor its financial situation to ensure that you are not left holding valueless unexercised options or even worse worthless acquired stock you can assemble a diversified options portfolio using listed options but with esos you have concentration risk since all your options have the same underlying stock in addition to your esos if you also have a significant amount of company stock in your employee stock ownership plan esop you may unwittingly have too much exposure to your company a concentration risk that has been highlighted by finra 7valuation and pricing issuesthe main determinants of an option s value are volatility time to expiration the risk free rate of interest strike price and the underlying stock s price understanding the interplay of these variables especially volatility and time to expiration is crucial for making informed decisions about the value of your esos in the following example we assume an eso grants the right when vested to buy 1 000 shares of the company at a strike price of 50 which is the stock s closing price on the day of the option grant making this an at the money option upon grant the first table below uses the black scholes option pricing model to isolate the impact of time decay while keeping volatility constant the second table illustrates the impact of higher volatility on option prices as can be seen the greater the time to expiration the more the option is worth since we assume this is an at the money option its entire value consists of time value the first table demonstrates two fundamental options pricing principles image by sabrina jiang investopedia 2020the table below shows option prices based on the same assumptions except that volatility is assumed to be 60 rather than the 30 shown above this increase in volatility has a significant effect on option prices for example with 10 years remaining to expiration the price of the eso increases 53 to 35 34 while with two years remaining the price increases 80 to 17 45 further on shows option prices in graphical form for the same time remaining to expiration at 30 and 60 volatility levels similar results are obtained by changing the variables with volatility at 10 and the risk free interest rate at 2 the esos would be priced at 11 36 7 04 5 01 and 3 86 with time to expiration at 10 five three and two years respectively image by sabrina jiang investopedia 2020the key takeaway from this section is that merely because your esos have no intrinsic value do not assume that they are worthless because of their long time to expiration compared to listed options esos have a significant amount of time value that should not be frittered away through early exercise image by sabrina jiang investopedia 2020risk and reward of owning esosas discussed in the preceding section your esos can have significant time value even if they have zero or little intrinsic value in this section we use the common 10 year grant term to expiration to demonstrate the risk and reward associated with owning esos 