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A stock option enables employees to purchase shares of a given class in consideration for a pre-determined amount referred to as the exercise price. The employees profit from a rise in the price of the shares, since the exercise price is pre-determined, but they have not yet paid for the shares. Obviously, options already have an economic value when they are allotted, since they award employees the right to buy shares for a fixed exercise price, but they are not committed to such payment unless they choose to exercise them. The right to exercise options is tied to a contract and the vesting period changes from one company to another. However, a customary option vesting period is four years, with 25% of the options vesting at the end of the first year and approximately one quarter of the options of each subsequent year vesting at the end of every quarter thereafter. Many employment contracts provide for accelerated vesting if the company is bought out by another company. Once the options have vested, employees may exercise them over a period of several years, in accordance with the terms of the option.
Example: An employee is allotted 100,000 options for an exercise price of $1 per share. The vesting period of the options is four years. Two years later, the company goes public and the stock price is $20 per share. At that time, the employee can exercise one half of the options and sell them on the stock exchange (subject to the lock-up provisions of the prospectus and the securities regulations of the exchange in which the shares are listed). Let us assume that the employee exercises and sells all of his or her 50,000 vested options. He or she pays the company $50,000 and receives $1 million when selling the stocks (before commissions and taxes).
In many cases, the company or a trustee on its behalf performs these actions on behalf of the employees and transfers the money to them after withholding the required amount of tax. The terms of the options and the use of trustees have a significant impact on the tax consequences.
The granting of stock options in a company enables the employees to become part of the group of owners of the company. It is an exceptional instrument which creates loyalty and identification with the company's goals (as an owner), encourages employees to stay with the company for a long period of time (in accordance with the vesting period of the options), motivates excellence (with the aim of helping to enhance the company's profits), and all with a low cash flow. From the company's point of view, the advantages of granting options rather than shares lie mainly in the fact that unexercised options entail no voting rights or a right to dividends, and in the fact that if the employee resigns before the end of the vesting period, he or she typically forfeits his or her right to this benefit. A distribution of shares creates a reduction of capital that requires special legal and accounting treatment, whereas when options are distributed and the employee does not want to receive (or exercise) them, they expire and "disappear."
On the other hand, there are also problems in granting stock options to employees. For instance, a decline in the value of the options due to daily market fluctuations may lower the employees' motivation. In addition, the decision of who will be compensated may cause problems with non-compensated employees (including good middle management). In practice, almost all companies now grant options to all employees in managerial positions, and it is not uncommon to see companies in which all employees, junior and senior, receive options. In addition, some restrictions are imposed by the securities laws on the distribution of securities to employees, and the distribution of options or other securities to employees involves a registration procedure or the receipt of a special exemption. Furthermore, the investors in the company might object to the dilution in their holdings in the company that is associated with the exercise of these options.
Various studies have recently cast doubt on the effectiveness of compensation in the form of shares and options, as is offered today. From the employee's point of view, the allotment of options provides a chance to profit, but the employee and the company perceive differently the risk involved in holding options instead of cash. In practice, if we compare an actual valuation of employee stock options, with an estimate of the value of the options as perceived by employees, it appears that employees perceive the value of options to be approximately one-half that perceived by neutral valuation. The researchers Murphy and Hall, for instance, describe the allotment of options in public companies as an expensive and inefficient way of compensating employees. Most of the managers' capital (both financial and human) is concentrated in the company they manage. Therefore, the portfolio of such managers is not well-diversified and, when evaluating the options allotted to them, they use a higher discount rate. Consequently, as a substitute for other compensation, they will require a larger number of options and shares than that called for by an evaluation made by the other investors in the company.
An alternative method for achieving the same targets—bonding the employee with the company for a long period of time and aligning the interests of the company and the employee—is a distribution of restricted shares within the framework of the employee's compensation package. These are shares that, like options, cannot be sold until after a certain vesting period, and enable employees to purchase a certain number of shares in each period for a price lower than the current market price. Since shares are less volatile than options, employees perceive them as being less risky and they are consequently cheaper to the company as a means of remuneration, although their economic nature is similar to that of options. |
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