Employee Stock Options 101: What you Need To Know
Employee stock options (ESOs) are an effective tool business owners can use to attract top notch talent to their organizations. While stock options are mutually beneficial for employers and employees, awarding them can be a tricky process. You'll need to know your company well in order to decide how much stock to award and to whom the options should be offered.
Before awarding ESOs, consider these important points.
Why Consider Stock Options?
Stock options are a great tool for employers for a variety of reasons:
- Encourages employees to think about long-term goals with the company
- Aligns employee and shareholder mentalities for overall company success
- Stock can be used as an alternate form of compensation to help with your budget
How to Determine the Price?
First, and most importantly, the exercise price must not be less than the market price of the company's stock on the date of the grant. Once you know your lowest possible price, consider the Black-Scholes model that many companies use when calculating an option price. The model is fairly complex, but the equation takes into consideration five variables:
- Current underlying price
- Options strike price
- Time until expiration
- Implied volatility
- Risk-free interest rates
Who to Consider
There are a number of ways a company can divide their stock based on an employee's role in a company.
As a rule of thumb, stock options should be given to key employees right away. If the company is new the valuation will likely be low. As the company ages, the value will hopefully grow accordingly along with the stock price.
After your key players have been taken care of you can start determining the amount of shares you have left in your pool.
Some businesses reserve stocks for different career achievements, such as:
- Outstanding performance
What is an Appropriate Vesting Schedule?
The initial offering of stock is generally used as a tool to retain employees vital to your success, and the vesting schedule can be seen as a tool to keep those employees from leaving. If your vesting schedule is too long, and the recipient sees the stock price as unattainable, it could be one factor in their leaving or declining a position with your company.
A common vesting schedule usually reaches full maturity in four years (25 percent vesting each year). You can also consider a vesting schedule that includes "trigger event" clauses with means stocks will vest by predetermined milestones for the company.
Caution: Loopholes Looming
Protect yourself and your company by being thorough with ESO paperwork. Ensure there is specific language written into your paperwork to help protect you from events like an employee being terminated without cause (especially if that employee's stocks are nearing their vesting date). There are many loopholes that ex-employees can work within to retain rights to their stock options.
Accounting Notes for ESOs
According to the Financial Accounting Standards Board, stock options must be recorded diligently:
- All stock option positions must be disclosed.
- The dollar values of compensation cost must be disclosed.
- The grant date fair value of each individual equity awarded must be disclosed.
- The option or stock appreciation right from the last fiscal year must be disclosed.
ESOs do not need to be expensed on the employer's income statements or stock appreciation right—for now anyway. There is debate within the accounting world in regard to whether ESOs should be expensed or not.