Employee Stock Compensation

An employee stock option (ESO) is a call (buy) option on a firm's common stock, granted to an employee as part of his compensation.

Learning Objective

Explain how employee stock options work and how a company would record their issue

Key Points

Options, as their name implies, do not have to be exercised. The holder of the option should ideally exercise it when the stock's market price rises higher than the option's exercise price. When this occurs, the option holder profits by acquiring the company stock at a below market price.
An ESO has features that are unlike exchange-traded options, such as a non-standardized exercise price and quantity of shares, a vesting period for the employee, and the required realization of performance goals.
An option's fair value at the grant date should be estimated using an option pricing model, such as the Black–Scholes model or a binomial model. A periodic compensation expense is reported on the income statement and also in additional paid in capital account in the stockholder's equity section.

Terms

exercise price
The fixed price at which the owner of an option can purchase (in the case of a call) or sell (in the case of a put) the underlying security or commodity.
remuneration
A payment for work done; wages, salary, emolument.
vesting period
A period of time an investor or other person holding a right to something must wait until they are capable of fully exercising their rights and until those rights may not be taken away.

Example

A company offers stock options due in three years. The stock options have a total value of $150,000, and is for 50,000 shares of stock at a purchase price of $10. The stock's par value is $1. The journal entry to expense the options each period would be: Compensation Expense $50,000 Additional Paid-In Capital, Stock Options $50,000. This expense would be repeated for each period during the option plan. When the options are exercised, the firm will receive cash of $500,000 (50,000 shares at $10). Paid-In capital will have to be reduced by the amount credited over the three year period. Common stock will increase by $50,000 (50,000 shares at $1 par value). And paid-in capital in excess of par must be credited to balance out the transaction. The journal entry would be:Cash $500,000 Additional Paid-In Capital, Stock Options $150,000 Common Stock $50,000 Additional Paid-In Capital, Excess of Par $600,000

Full Text

Definition of Employee Stock Options

An employee stock option (ESO) is a call (buy) option on the common stock of a company, granted by the company to an employee as part of the employee's remuneration package. The objective is to give employees an incentive to behave in ways that will boost the company's stock price. ESOs are mostly offered to management as part of their executive compensation package. They may also be offered to non-executive level staff, especially by businesses that are not yet profitable and have few other means of compensation. Options, as their name implies, do not have to be exercised. The holder of the option should ideally exercise it when the stock's market price rises higher than the option's exercise price. When this occurs, the option holder profits by acquiring the company stock at a below market price .

General Foods Common Stock Certificate

Publicly traded companies may offer stock options to their employees as part of their compensation.

Features of ESOs

ESOs have several different features that distinguish them from exchange-traded call options:

There is no standardized exercise price and it is usually the current price of the company stock at the time of issue. Sometimes a formula is used, such as the average price for the next 60 days after the grant date. An employee may have stock options that can be exercised at different times of the year and for different exercise prices.
The quantity of shares offered by ESOs is also non-standardized and can vary.
A vesting period usually needs to be met before options can be sold or transferred (e.g., 20% of the options vest each year for five years).
Performance or profit goals may need to be met before an employee exercises her options.
Expiration date is usually a maximum of 10 years from date of issue.
ESOs are generally not transferable and must either be exercised or allowed to expire worthless on expiration day. This should encourage the holder to sell her options early if it is profitable to do so, since there's substantial risk that ESOs, almost 50%, reach their expiration date with a worthless value.
Since ESOs are considered a private contract between an employer and his employee, issues such as corporate credit risk, the arrangement of the clearing, and settlement of the transactions should be addressed. An employee may have limited recourse if the company can't deliver the stock upon the exercise of the option.
ESOs tend to have tax advantages not available to their exchange-traded counterparts.

Accounting and Valuation of ESOs

Employee stock options have to be expensed under US GAAP in the US. As of 2006, the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB) agree that an option's fair value at the grant date should be estimated using an option pricing model. The majority of public and private companies apply the Black–Scholes model. However, through September 2006, over 350 companies have publicly disclosed the use of a binomial model in Securities and Exchange Commission (SEC) filings. Three criteria must be met when selecting a valuation model:

The model is applied in a manner consistent with the fair value measurement objective and other requirements of FAS123R;
is based on established financial economic theory and generally applied in the field;
and reflects all substantive characteristics of the instrument (i.e. assumptions on volatility, interest rate, dividend yield, etc.).

A periodic compensation expense is recorded for the value of the option divided by the employee's vesting period. The compensation expense is debited and reported on the income statement. It is also credited to an additional paid-in capital account in the equity section of the balance sheet.

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